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Three Underperformers That Don't Add Up

This article originally appeared Jan. 27, 2014, on Real Money. To read more content like this, + see inside Jim Cramer's multi-million dollar portfolio for FREE -- Click Here NOW.


I have been asked several times if I think this is a great buying opportunity, and the only thing I can do is wonder what everyone is thinking. So far, this is just a bump in the market advance. It may turn into something more serious, but it has not yet created any excess of inventory for value investors. The stuff that is down this year is the same stuff that has been going down for some time now, like miners and energy. Shipping stocks have been selling off a little but most of these have had huge runs and it's not yet time to think about initiating or adding to positions in most of the group.

It is time to think about playing defense in your portfolio. I have no idea if the selling begins again and takes us to substantially lower levels. I do know that if it does, the last thing you want is to be caught holding companies that are richly valued yet have poor fundamentals and prospects. Even if the market shakes off the emerging-market problems and continues to rally it is likely that these stocks underperform substantially, so there really doesn't seem to be many reasons to hold them.

CarMax (KMX) is a good example of such a stock. The auto dealer is just not seeing anywhere near the growth to justify the current 20 price-to-earnings ratio and price-to-book-value ratio of more than 3. The company is seeing single digit earnings growth this year and this will likely be the case next year as well. The Enterprise Value-to-EBITDA ratio is a whopping 17, so it is tough to make a case for the stock being reasonably priced . The prospects do not look all that promising as the Piotroski F-score is 2 on a scale of 0 to 9, indicating the operating and financial conditions are getting worse, not better. There is no strong reason to own or hold the stock now.

Another stock that doesn't measure up and should be avoided is iRobot (IRBT). This company has a great story with robot appliances and robots for military and home-defense markets. I love a good story, but the company just doesn't measure up when you look at the numbers. Earnings are down this year and the company will probably see single-digit growth for the next three to five years. The demand is not there yet. There is nothing in the company's fundamentals that make me want to own the shares. The stock sells at 57x earnings and more than 3x book value and an EV/EBITDA ratio of 24. The F-score is just 3, so conditions don't look they will improve any time soon.

Toll Brothers (TOL) has struggled all year and the stock has not been the top performer it was in2012. It doesn't look like conditions will improve for the company any time soon and it is richly valued right now. The housing market may be recovering but it only takes a bump or two in interest rates to slow things down in this industry. Anecdotally, I can tell you that Central Florida seems to be over building anew already and I am hearing similar stories for the sunshine markets around the country. Turning back to the numbers, the stock trades at 1.8x book and 37x earnings with an EV/EBITDAS ratio of 34. The F-score is 3, so conditions may be getting worse, not better, for the luxury homebuilder. It is the class of the industry but there is currently no valid reason to own the shares.

I am not a market-timer by any stretch, but there are signs that the market may be overpriced. I do know that richly valued companies usually lead the market down in a selloff and that companies with low F-scores underperform the broader market. It makes sense to combine these two factors and look for stocks that have the potential to  harm our portfolios on the downside and offer little upside potential.

At the time of publication, Melvin had no positions in the stocks mentioned.

At the time of publication, Melvin was long XXX, although positions may change at any time.

Tim Melvin is a writer from Stevensville, Maryland, who spent 20 years a stockbroker, the last 15 as a Vice President of Investments with a regional firm in the Mid Atlantic area. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Melvin appreciates your feedback; click here to send him an email.

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