Avoid These 3 "Hot" Stocks

David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Investors who backed Home Depot, Lowe's, and Lumber Liquidator over any of the last few months would have seen terrific returns. At this point, however, multiples are elevated while the bar has been set high for growth. I thus recommend avoiding these stocks until multiples depress slightly or after we get a greater sense of investor preferences during a full recovery.

Home Depot (NYSE: HD): Strong Momentum But Still Overvalued

Home Depot may have been on an impressive run for the year to date, but most good things need to come to an end. While the housing market has largely recovered, it still remains uncertain and does not justify Home Depot's current PE multiple of around 19.7x. If the company is able to achieve its 13.7% annual EPS growth rate over the next half decade, however, the current valuation is justified at a 10% discount rate.

From a competitive position, Home Depot has yielded impressive results. Lowe's has moved out mostly from areas where Home Depot is near. Moreover, I like the company's focus on penetrating markets in Canada, the United States, Mexico, and China. According to BMO Capital Markets, management has guided for low-single digit growth in same-store sales this year, but the outlook has likely improved since management ties forecasts largely to GDP figures, which have been better-than-expected.

And from a cost perspective, the company is well positioned. Around half of corporate expenses, BMO argues, are fixed. While normally this causes expenses to be leveraged as sales pick up, management now has the proper supply chain system to push down expenses if sales slow. However, I believe, it is more important to look at the growth curve. With no new stores planned for Canada this year and next, I believe management is holding a reserved outlook on the future. Home Depot has performed well in Canada, so their inaction begs the question every kid loves to ask: "why?"

Lowe's (NYSE: LOW) & Lumber Liquidators (NYSE: LL) Also Too Be Avoided

Lowe's similarly does not look like it's worth an investment. It trades at a respective 20.8x and 15.5x past and forward earnings with a dividend yield of 2%. Though ROE is in the double-digits, the current ratio of 1.3x could be better. Shares have soared 57.5% from the 52-week low and now hover around the 52-week high. With limited free cash flow generation against the market cap (a 4.2% yield), I believe the company is financially weaker than what it's operations would suggest.

Moreover, I believe analysts are overly bearish on the future growth outlook. Over the last 5 years, Lowe's EPS has fallen by 6.3% annually, yet the rate is forecasted to jump more than 2,000 bps to 21.7%. There is considerable risk that the company won't meet this high bar and that, even if it does, investors won't bear the fruit because the multiples are already so elevated.

Instead, you may decide to back momentum stock Lumber Liquidators. The stock has skyrocketed 273.4% from its 52-week low, and it still is projected for 17.1% annual EPS growth over the next 5 years. But I fear that investors have become overreactive to earnings announcements. The third quarter beat, for example, sent shares soaring 13.8% - at a PE multiple of 35.9x, I am not so sure that this double-digit reaction is warranted. Yes, revenue growth of 19% y-o-y was impressive that management rightfully had to up earnings to a high end of $1.59 from $1.42, but Hurricane Sandy will be a notable headwind. The media has argued that it will hit Home Depot and Lowe's sales in the fourth quarter but has yet to do the same for Lumber Liquidators. This double-standard is just another reason to not get hooked on this hot stock.


TakeoverAnalyst has no positions in the stocks mentioned above. The Motley Fool owns shares of Lumber Liquidators. Motley Fool newsletter services recommend The Home Depot, Lumber Liquidators, and Lowe's Companies. 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 Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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