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When you're seeking tantalizing investments for your portfolio, it makes a lot of sense to look for undervalued stocks to buy and overvalued ones to consider avoiding or shorting. Some folks, though, look for "overbought" stocks to avoid or sell, and "oversold" ones to buy. I know some will disagree, but I think that's silly.
The terms "overvalued" and "undervalued" have a key component in them: value. They compare a stock's current price with an estimate of its intrinsic value, perhaps by taking into account numbers such as price-to-earnings (P/E) ratios or growth rates. This is part of "fundamental" stock analysis, where an investor assesses a company's health, competitive strengths, and growth prospects, poring over financial statements.
Its opposite is "technical" analysis, which involves focusing on stock-price movements and looking for trends, among other things, while largely ignoring the actual businesses behind the stocks. That's how you end up with so-called overbought stocks, which might be defined as those that are trading at prices substantially above their 50-day moving average. Interestingly, while some technical investors might avoid such companies, expecting them to pull back, others who like to chase momentum will be attracted to them, assuming that they'll keep moving forward, at least for a while. (Technical analysis isn't known for its patience.)
Let's look at three companies that some recently believed were overbought: Level 3 Communications (Nasdaq: LVLT ) , having moved 28% beyond its 50-day moving average as of early July; Green Mountain Coffee Roasters (Nasdaq: GMCR ) , 21% beyond; and Riverbed Technology (Nasdaq: RVBD ) , 14% beyond.
Coffee and communications
There's much more to these companies than just their stock prices, though, and they vary in how undervalued or overvalued they seem. Green Mountain Coffee Roasters, for example, has been a market darling for quite a while, roughly doubling annually, on average, over the past five years. You could have said that it was overbought pretty much that entire time! Right now, its P/E ratio is roughly twice its five-year average, and some patents are expiring soon. But then its heady growth rate makes its valuation not so outrageous, and it's inked an attractive deal to fill its Keurig K-cups with Starbucks (Nasdaq: SBUX ) coffee. It's not so hard to see why many people have been buying its shares.
Meanwhile, Level 3 Communications' stock has also been on a tear, partly because of its multiyear deal to facilitate Netflix's (Nasdaq: NFLX ) streaming service. Some are also bullish on its purchase of Global Crossing (Nasdaq: GLBC ) . But the company has heavy debt, has been posting losses for years, and is financing that hefty purchase with stock, thereby diluting existing shares. It seems much more overvalued than Green Mountain Coffee Roasters.
Finally, Riverbed Technology also has a steep P/E, well into the triple digits and topping its five-year average. But its forward P/E, based on expected future earnings, is a much more reasonable 35, especially considering that the company's revenue rose 40% in 2010. The company also sports no debt, rising profit margins, and a strong position in its business of boosting performance of online traffic. It even has an agreement with competitor Akamai Technologies (Nasdaq: AKAM ) to run each other's software on each other's networks, thereby improving service for both companies. Even if you deem the shares a little rich, it seems like a very promising long-term investment -- and some have suggested that a technology heavyweight may want to snap up the company one of these days. For someone to dismiss it because its price is above a 50-day moving average seems rather shortsighted.
Thinking of stocks as overbought or oversold is silly. Some stocks surge because they deserve to, as they approach their intrinsic value from a more undervalued level. Others are indeed getting ahead of themselves. Some may sport strong balance sheets and robust expected growth, while others may be on shakier ground because of debt or unprofitability. It's not likely to boost your portfolio if you ignore the businesses behind the various stocks you examine.
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