3 Overvalued Stocks

THE VALUE INVESTOR: These stocks are trading above their fair market value - could it be time to trim your profit?

Emma Wall 18 December, 2014 | 11:00AM

UK equity markets have moved sideways this year – but these three stocks have made gains. Is it time to trim profit from these three overvalued companies? They remain attractive for the long-term investor thanks to their economic moats – or competitive advantage over their peers – and income prospects, but this may be an opportunity to use gains to invest in other less-pricey stocks.

ARM Holdings (ARM)

ARM holds an extensive library of microprocessor intellectual property and has particular expertise in low-power high-performance chip architectures. ARM's IP is the backbone of most processors used in mobile devices today, and strong tailwinds from both the shift to higher-end smartphones and the proliferation of connected devices as part of the “Internet of Things” should bode well for ARM in the years ahead. ARM essentially develops the blueprints that allow a variety of leading chipmakers, such as Qualcomm, to design many of their semiconductors.

Just as Intel's chips dominate the PC market, ARM-based chips are found in almost all handsets, where low power and longer battery lives are critical factors. In exchange for its IP, ARM collects both an up-front license fee and ongoing royalties based on the price of each ARM-based chip sold. The source of ARM's wide economic moat, in our opinion, is intangible assets stemming from the firm's IP, as well as the strong ecosystem of partners around the ARM platform.

National Grid (NG.)

Since regulators in the United Kingdom unbundled energy distribution, transmission, and supply in the 1980s, National Grid has grown into one of the world's largest utilities. National Grid began acquiring Northeast U.S. utilities in 2000, and made its biggest move buying New York-based Keyspan for $11.8 billion in August 2007. It now earns about 30% of its profits from the U.S., a share that continues to shrink as National Grid invests more heavily in the U.K., where the regulatory environment is more constructive.

With its U.K. rate structure set through 2021, National Grid offers transparent earnings and dividend growth. Even though the dividend likely won't grow at the 10% annual clip it did between 2005 and 2012, we still think it can grow in line with or faster than inflation. With a dividend yield that has been consistently above 5%, we think the stock offers attractive total returns given the stability of its business model.

Smith & Nephew (SN.)

Smith & Nephew's impressive innovation has allowed the firm to carve out a slice of the orthopaedic and wound-care markets. Though Smith & Nephew is smaller than the dominant orthopaedic competitors, it has been a strong contributor in terms of introducing meaningful innovation. The firm pioneered hip resurfacing, which enlarged the patient pool by giving people in their late 40s and early 50s an option to address their worsening hips instead of waiting until a full-blown hip replacement was appropriate.

Smith & Nephew launched a new knee replacement with Verilast technology, which the firm contends can last for 30 years. Again, this technology helps Smith & Nephew attract younger patients, as well as any patients concerned about the prospect of revision replacement down the road.

We used Morningstar Select to screen for stocks that were trading above their fair value estimate as determined by Morningstar Equity Analysts

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar
National Grid PLC980.09 GBX0.35
Smith & Nephew PLC1,889.00 GBX-0.16

About Author

Emma Wall  is former Senior International Editor for Morningstar

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