Investors have been taken on a wild ride over the last decade, including having to witness the broader market stock indexes losing more than half of their value and then subsequently rebounding by 200%, or in the Nasdaq's case, 300%.
We don't have to look far to understand why the stock market is on the mend, however. The U.S. economy has once again found its rhythm and merger and acquisition activity is up, implying that businesses' long-term outlooks and appetite for risk have improved, and investors are eager to hit the buy button.
But with an overwhelmingly bullish group of investors comes the possibility that the market has gotten ahead of itself. According to FactSet, the S&P 500's forward P/E ratio as of February was 17.1. That may not seem very high, all things considered, but it represents the most aggressive forward P/E since December 2004. As valuations increase, the call for a major correction in the market's most overvalued stocks grows.
Overvalued isn't always a bad thing
However, not all stocks that are perceived to be overvalued based on traditional fundamental metrics are worth avoiding. Sometimes, overvalued stocks can remain overvalued over the long term and head even higher. One could even surmise that overvalued stocks are "overvalued" in the first place because they present competitive advantages over their peers. Those are the companies we're looking to fish out today when looking for the best deals in overvalued stocks.
Chiptole Mexican Grill (NYSE:CMG)
Sometimes, a competitive edge emerges based on consumers' perception of a business. The transparency that fast-casual Mexican restaurant chain Chipotle brings to the table is what could propel its valuation higher for years to come.
Chipotle's "Food With Integrity" campaign is a very powerful tool that drives health-conscious consumers into its stores and away from traditional fast-food restaurants. Under its campaign, Chipotle promises to serve antibiotic- and hormone-free meats when possible, and it does a good job of supplying its restaurants with fresh fruits and vegetables from local growers. Consumers got a good taste of Chipotle's integrity when it removed pork from its menu in January after discovering that one of its suppliers wasn't living up to its end of the bargain. Putting consumers over profits is a good way for a company to build trust.
Chipotle's menu is also constantly innovating, with food ultimately prepared right in front of the customer. There's no guesswork as to what's going on in the kitchen when you enter a Chipotle, and there's rarely ever a long wait, ensuring that time constraints don't send health-conscious consumers elsewhere.
Its game plan is currently being executed to perfection. It's been able to pass along price hikes caused by higher input costs (e.g., ground beef and avocado prices rising) with essentially little pushback from consumers, and it delivered 14.1% sales growth, including 4.3% comparable-store sales growth, in its latest quarter.
In my opinion, it's possible Chipotle's stock could challenge the $1,000-per-share mark within a few years.
American Tower (NYSE:AMT)
If you're looking for a perceived-to-be overvalued company with limitless profit potential, then look no further than antenna tower owner and lease, American Tower.
American Tower isn't a cheap stock. Buying here would mean you'd be paying 60 times trailing 12-month earnings and about 38 times its forward profit estimates. But, these lofty figures are easy to overlook once you dig into American Tower's business model.
As of the end of its latest quarter American Tower owned around 97,000 antenna towers. These towers are primarily used by cellular providers for data transmission on their high-speed data networks. As these networks become more sophisticated (e.g., 4G LTE, and eventually 5G), and consumers' smartphones evolve to become faster, the demand for data transmission is only going to explode upwards. Just as wireless providers have consumers by the noose since there are relatively few to choose from, antenna providers have a hand up on the wireless industry because there are few communication tower providers to choose from. For American Tower it means the ability to negotiate long-term contracts that provide predictable cash flow, as well as contracts that are priced in its favor.
American Tower is also able to use its favorable tax status as a real estate investment trust to boost its business and line the pockets of its investors. A REIT is required to return 90% or more of its profits to investors in the form of a dividend. In return, the REIT avoids corporate tax rates. This move allows American Tower to funnel its cash back into the business. For example, in early July it acquired nearly 4,700 antenna sties from Airtel Nigeria. Acquisitions are commonplace for American Tower, and they give the company a quick way to boost its cash flow.
Sporting a 1.8% annual yield and offering extremely attracting long-term growth potential, I believe this is an overvalued stock that's nowhere near done heading higher.
AvalonBay Communities (NYSE:AVB)
Lastly, I'd turn your attention to yet another REIT, this time in the homebuilding sector.
AvalonBay Communities owns and operates 283 apartment communities around the U.S., which are comprised of close to 83,000 apartment homes. What separates AvalonBay from its peers is that it has a very specific target in mind with its apartment communities: middle-upper to upper income earners. More affluent renters offer an advantage to AvalonBay that you rarely see for other residential REITs in that they're far less affected by fluctuations in the U.S. economy. In short, affluent renters continue to pay their rent when U.S. economic growth slows, which isn't always the case for its peers.
The state of the current economic environment is also very conducive to further growth. GDP growth in the U.S. has been steady, leading consumers to feel especially comfortable paying a premium price to live in an Avalon-owned community. More importantly, though, the Federal Reserve has made no secret of the fact that lending rates are expected to rise very soon. Rising lending rates will probably push mortgage rates up, and it could wind up discouraging renters from buying a home. Rising rates have a strong tendency to reinforce the rental pricing power of apartment communities and it usually boosts their occupancy rates.
In the latest quarter Avalon's occupancy rates fell a tad (which isn't horrible news since it's regularly in the mid-to-upper 90-percentile), but its average rental rates rose a robust 5% across the country. AvalonBay's trailing P/E of 31 doesn't imply you're getting a great bargain, but this company's niche role in the rental community, and its generous 2.9% yield, could push its stock significantly higher over the long run.