Given how much stock prices have fallen over the past month or so, lots of investors are salivating at picking up stocks on the cheap. But before you just jump in and buy whatever particular stock you happen to follow, you need to take a closer look at whether the overall market's drop has really brought that stock price down far enough to make it a bargain.
A market of stocks
It's easy to look at the Dow or the S&P and think that every stock must move the same way the overall market does. Sure, sometimes a company has good news on an otherwise bad day that lets its stock buck the downward trend. And plenty of times, the opposite happens: bad news causes a stock to plummet even when most stocks are up. But with things like program trading and ETFs making stock prices ever more interconnected, you can often see how a move in the overall market brings shares of companies down almost in lockstep over short periods of time.
But if stocks move largely in tandem over extremely short periods of time, long-term stock price movements have much more to do with the fundamentals underlying each company. A market may move up strongly for a long time, but if a company can't take advantage of those good conditions to stay profitable and grow, then investors will abandon its stock in favor of some other investment.
And when markets drop suddenly, as they have over the past month, it separates the best companies from the rest. If a company was already undervalued compared to its future prospects, then a market swoon can make it even more attractive. But by contrast, if a stock had a rich valuation, even a fairly large downdraft won't necessarily make the shares cheap.
Waiting for deeper discounts
It's that last group of stocks that I want to look at today. To find stocks that may still be overpriced even after a healthy drop, I searched for large-cap stocks that had dropped at least 10% but whose shares are still priced at 30 or more times trailing earnings and at least 25 times forward earnings estimates -- yet which are expected to grow at no more than 20% over the long run. Weeding out real-estate investment trusts and some other specialty investments, here are eight stocks that came up on the list:
Estimated Long-Term Growth Rate
Cerner (NAS: CERN)
Whole Foods (NAS: WFM)
Intuitive Surgical (NAS: ISRG)
Informatica (NAS: INFA)
Fortinet (NAS: FTNT)
Martin Marietta (NYS: MLM)
Toll Brothers (NYS: TOL)
Source: Capital IQ, a division of Standard & Poor's.
Comparing earnings multiples to growth rates may be a simplistic way to judge valuation, but it at least gives you a starting point for your research. You can tell from how much these stocks have already dropped that they had even higher valuations just a month ago -- yet those growth rates, while impressive in many cases, may not be enough to support them.
What's a bargain?
So does that mean you shouldn't buy any of these stocks? Not at all. Just as a shopper knows which brands will have deep discounts and which others never go on sale, so too do some stocks consistently trade at premium valuations compared to the market -- especially those with fast growth rates. If you're a diehard value investor, you may never look at high-growth stocks like these, because they'll never meet your strict price requirements. Yet as long-term investors in most of these stocks will tell you, even without obvious cheap points to get in, these companies have made a lot of money for their shareholders.
But a couple stocks on the list don't fit that mold. Martin Marietta, which produces aggregates for the construction industry, has struggled for years as new construction founders in U.S. markets. Similarly, Toll Brothers has searched for a bottom for the housing market for years, thus far without success -- and although the homebuilder is one of the few that's actually profitable right now, the prospects for those profits going forward are far less certain.
So before you go grab whatever stock happens to be down a bit, think twice about whether it's going to make money for you. Often, stocks that are still overpriced can fall quite a bit further before they hit bottom.
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At the time thisarticle was published Fool contributorDan Caplingermay be cheap but he's a stickler for good stocks. You can follow him on Twitter here. He doesn't own shares of the companies mentioned in this article. The Motley Fool owns shares of Whole Foods. Motley Fool newsletter services have recommended buying shares of Informatica, Intuitive Surgical, Whole Foods, and Stericycle. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Fool'sdisclosure policyis free to a good home.
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