The market tends to underprice securities that are in a cyclical downturn and overprice securities that are in the midst of a cyclical upturn. Determining whether or not a security is severely underpriced or severely overpriced is not a difficult task, but making a determination about the investment merits of a security that is not priced at one of those extremes can be a difficult task.
Unfortunately, it is at the point when a security is on the verge of becoming severely overpriced that many individual investors start buying it. This seems to be the case with housing-related stocks, especially The Home Depot, Inc. (NYSE:HD), Lowe’s Companies, Inc. (NYSE:LOW), and Lumber Liquidators Holdings Inc (NYSE:LL). Investors who buy these stocks today are acting as a lifeboat for Wall Street money managers that recognize the stocks’ severe overpricing.
Recovery in housing
Although the broader economy has remained sluggish, a recovery in the U.S. housing market is well underway. This has boosted sales at The Home Depot, Inc. (NYSE:HD), Lowe’s Compnies, Inc. (NYSE:LOW), and Lumber Liquidators Holdings Inc (NYSE:LL)and will continue to do so as long as the recovery continues at a robust pace.
The Home Depot, Inc. (NYSE:HD)’s stock price has increased significantly over the last year, but not without reason. After over-expanding during the housing boom, the company is now a leaner and more focused company than it was heading into the housing bust.
Aside from operational missteps associated with supply chain management and investing outside of its core competencies, management has been extremely shareholder friendly; it uses the bulk of free cash flow to repurchase shares and pay a dividend. The share repurchase program has led to a significant reduction in shares outstanding over the last decade.
Meanwhile, Lowe’s Companies, Inc. (NYSE:LOW) continues to excel as a company known for providing a good customer experience, including appealing stores and outstanding customer service. The company is pursuing an aggressive strategy to roll out its own brands in an effort to boost margins. Along with its efficient supply chain and industry-leading information technology infrastructure, the strategy should help Lowe’s Companies, Inc. (NYSE:LOW) expand its margins as the housing recovery plays out.
However, as the domestic market becomes saturated with big box construction products stores, The Home Depot, Inc. (NYSE:HD) and Lowe’s Companies, Inc. (NYSE:LOW) will likely start competing more fiercely with each other. This can only mean lower profits going forward.
Lumber Liquidators, on the other hand, is relatively immune to the intense competition that The Home Depot, Inc. (NYSE:HD) and Lowe’s must face. As the largest U.S.-based retailer of hardwood flooring, Lumber Liquidators sells its products at a price few competitors can match.
Sales, and the company’s stock price, have increased dramatically alongside the recovery in housing. Management forecasts $913 million to $942 million in sales for 2013 — 12% to 16% growth compared to 2012.
But Lumber Liquidators is no different than The Home Depot, Inc. (NYSE:HD) and Lowe’s in the sense that its prospects have brightened, but its stock price has run up much higher than its normal earning power is worth.
Priced for suckers
Over the last four quarters, Home Depot has earned $3.91 per share in free cash flow — far higher than it has earned in the last decade and much higher than its normal earning power. The stock recently traded around $80 per share, so investors are getting a 4.9% initial yield ($3.91/$80) based on inflated earnings. This means that if Home Depot can pull off a miracle and routinely earn about $4 per share from here on out — a virtual impossibility — shareholders will get a 5% compound annual return.
Lowe’s also recently reported record free cash flow per share; in its fiscal year ended January 2013, Lowe’s earned $2.21 per share in free cash flow — a 5.3% yield on its recent stock price.
For Lumber Liquidators, I will give it the benefit of the doubt and use the higher GAAP earnings figure to calculate its earning power. The company earned a record $1.96 per share over the last four quarters — a 2.4% earnings yield.
Bottom line
Short-term momentum traders may be able to buy these stocks and flip them to a greater fool, but long-term shareholders need to understand that they are the fool if they buy any stock with a maximum upside of 5%. Home Depot, Lowe’s, and Lumber Liquidators are all trading at rich multiples of record earnings — long-term investors should avoid them.
The article Are Housing Stocks Overpriced? originally appeared on Fool.com.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Home Depot, Lowe’s, and Lumber Liquidators. The Motley Fool owns shares of Lumber Liquidators. Ted is a member of The Motley Fool Blog Network — entries represent the personal opinion of the blogger and are not formally edited.
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