It's no surprise that emotional, trend-seeking investors often chase top performers in hopes of cashing in on momentum that may very well have already passed them by.
Fundamental investors, on the other hand, typically take a more surgical approach by looking for stocks that not only appear undervalued relative to their peers but are also poised to benefit from some sort of catalyst.
Clearly, the media attention and outsized returns of the market's big winners can skew investors' judgement, causing them to blindly believe the upward trajectory will continue, rather than paying sufficient attention to the metrics and valuations.
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The sky's the limit
One glaring example, in my opinion, is Palantir Technologies (PLTR +4.56%). Its over 100 percent move so far this year, alongside its over 400 percent spike over the past 12 months, has left it at the tippity-top of the S&P 500's performance list, beating out almost all of its peers, depending on recent trading action. Impressive stuff for sure.
NASDAQ: PLTR
Key Data Points
For investors thinking about jumping on the Palantir bandwagon, who are unsatisfied with owning it indirectly as a member of the XLK, SPY or hundreds of other funds and ETFs, I would argue that the price of admission, on a valuation basis, is simply too high.
Specifically, if you were offered an opportunity to buy the single most expensive stock in the S&P 500 on a forward PE basis (Price-to-Earnings Ratio on estimated earnings over the next 12 months, P/E NTM) , that, according to Koyfin data, is trading at 218 times expected earnings, I would guess that you might look elsewhere for something a little cheaper. By comparison, the forward P/E for the Technology Select Sector SPDR Fund (XLK +2.20%) is currently trading around 30×, according to State Street Global Advisors. Said another way, some healthy skepticism -- if not a hard pass -- would be more than warranted, at least for the short term.
At the same time, on a Price to Sales (P/S) basis, the Denver-based data analytics firm is also selling at Rolls Royce-like valuations, thanks to its index topping P/S ratio of 74x, which is roughly 10-times the average P/S ratio of the XLK.
This is not to say that Palantir is a bad business or somehow doomed as a stock. I'm simply pointing out that if you are determined to go into the market and buy at this level, you're not only going to pay through the nose to do so but your risk-reward ratio will likely be upside down too.
Warning bells below
Switching industries and moving down scale in terms of market cap, numerous other valuation traps can be found.
Take Kohl's (KSS 2.46%), for example. While the struggling retail chain recently delivered a better than expected quarter at the end of August, its stock has richly benefited in the short term, as well as from being dubbed a meme stock and gaining favor with active traders. This, despite the fact that Kohl's reported its second quarter total revenues, same store sales and earnings all fell year on year, while management also told investors that it expects sales will continue to decline while profitability will only improve modestly.
My point here is that to most investors, that would seem like a lackluster outlook, and yet, the retailer's shares have been bid up by more than 150% over the past 5 months. It's also worth noting that even though it has led the S&P Retail ETF (XRT) since April, Kohl's stock is still down nearly 20% from a year ago.
NYSE: KSS
Key Data Points
To be sure, traders who caught this bounce have been handsomely rewarded over the past few months, but the outlook and guidance have yet to sway many minds on Wall Street.
Although analysts' estimates change all the time, at least one gauge of institutional support suggests that the Wisconsin-based retail chain might be a little ahead of itself. Specifically, at current levels near $16.50 per share, Kohl's is now trading about 14% above the average 12-month price target of $14.28 per share. Add in the fact that Koyfin data shows that 13 of 15 analysts, or 86%, currently rate Kohl's either hold or sell, further limiting the probability for its rally to continue.
Price Matters
To be sure, forward P/E and Price to Sales ratios should not be the only metrics you use when considering an investment, as many top performing high-growth companies trade at high valuations, or even no valuations if they have yet to turn a profit. To that point, The Motley Fool has written extensively on the opportunities that exist to buy undervalued companies after a broad market decline, while also citing Warren Buffett and others who have warned against the risks of trying to time the market vs buying quality companies for the long term.
That said, while shares of Palantir and Kohl's are each currently dominating their respective sectors, I would argue that the sentiment, valuations and outsized market performance surrounding these two companies should be viewed cautiously. With that in mind, I would suggest new buyers wait for a better entry point, or at the very least, take a stake in a fund or index ETF if that base is not already covered.
