How Quality Stocks Can Be Dangerous Investments

Investors should be careful around Canadian Apartment Properties REIT (TSX:CAR.UN) and two other stocks, even though their businesses are doing fine. Find out why.

| More on:
The Motley Fool

Ideally, investors want to fill their diversified portfolios with quality stocks. There’s no doubt that Canadian Apartment Properties REIT (TSX:CAR.UN), Andrew Peller Ltd. (TSX:ADW.A), and Richelieu Hardware Ltd. (TSX:RCH) have been excellent stocks recently. However, it can be dangerous to have these stocks in your portfolio when they’re excessively expensive.

What might quality stocks look like?

Canadian Apartment REIT, or CAPREIT, stock has performed well. Since it was reasonably valued in the summer of 2013, the stock has delivered returns of 16.6% per year.

Andrew Peller stock has been extraordinary. Since the breakout in July 2015, the stock has delivered returns of more than 40% per year.

Since late 2012, when Richelieu stock traded at a reasonable multiple, it has delivered annualized returns of as high as 25%.

Notably, the run-ups of these stocks have been supported by growing profitability on a per-share basis — at least initially. As more investors jumped in to the stocks, their share prices moved higher until the stocks became excessively overvalued and the momentum was lost. And that’s where the danger lies.

The danger

A big portion of CAPREIT’s gains come from the stock trading at a premium multiple.

At about $43.20 per share, CAPREIT trades at a price-to-funds-from-operations ratio of nearly 23, while the residential REIT is estimated to grow its funds from operations per unit by about 4% per year, roughly in line with the long-term inflation rate.

The fact stands that the incredible stock remains strong, and no one knows when the market will realize how expensive the stock is. Perhaps a sell-off will be triggered at one point by bad news in the residential real estate market.

Although Andrew Peller stock trades at a multiple of about 23, it has been experiencing higher growth than CAPREIT. In fiscal 2018, its organic sales growth was 5.4%, while its winery acquisitions in late 2017 seem to have boosted the company’s return on equity, leading to earnings-per-share growth of 11% for the year.

In Andrew Peller’s recent document, it stated, “Currently, the company has an estimated 14% share of total volume of the wine market and a 37% share of total volume of the domestic wine market, with the company’s Peller Estates brand the top‐selling wine in this market.”

The company has a clear position in the wine market. However, consumer tastes can change. So, it’ll need to think of ways to maintain or even expand its market share.

Andrew Peller stock has experienced weakness in the last week. Only time will tell if this is the start of a sell-off.

Richelieu stock was excessively expensive in late 2017, and that’s why the stock has underperformed year to date by falling about 18%.

Investor takeaway

The three examples discussed here are very different businesses. So, they cannot be compared directly. What they have in common is that their share prices have had a run-up, which was at least initially supported by growing profitability.

However, at one point, the share price gets ahead of the company’s growth, and when the market realizes that the stock has become excessively overvalued, we could see a sell-off (and we’ve started seeing this in Richelieu stock), and that’s where the danger lies.

No matter how high quality a business is, investors should be cognizant of how much they’re paying for a stock. If you pay too high a multiple for stocks, your returns will suffer.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium service or advisor. We’re Motley! Questioning an investing thesis — even one of our own — helps us all think critically about investing and make decisions that help us become smarter, happier, and richer, so we sometimes publish articles that may not be in line with recommendations, rankings or other content.

Fool contributor Kay Ng has no position in any of the stocks mentioned.

More on Dividend Stocks

TFSA (Tax-Free Savings Account) on wooden blocks and Canadian one hundred dollar bills.
Dividend Stocks

TFSA Investors: Buy These 3 Stocks for $3,480 Yearly Tax-Free Income

One significant benefit of a TFSA-based dividend income is that it doesn’t weigh down your tax bill.

Read more »

Canadian dollars in a magnifying glass
Dividend Stocks

3 High-Yield Dividend Stocks That Are Screaming Buys Right Now

Are you looking for great income stocks? Here's a trio of high-yield dividend stocks that pay insane yields right now.

Read more »

Piggy bank with word TFSA for tax-free savings accounts.
Dividend Stocks

Transform a $5,000 TFSA Into a $50,000 Retirement Nest Egg

The TFSA is a powerful tool that can grow a small investment into a substantial retirement nest egg over time.

Read more »

A meter measures energy use.
Dividend Stocks

Is Fortis Stock a Buy, Sell, or Hold for 2025?

Fortis has increased its dividend annually for the past five decades.

Read more »

analyze data
Dividend Stocks

3 Dividend Stocks That Are Screaming Buys in November

Here are three top dividend stocks long-term investors won't want to ignore during this part of the market cycle.

Read more »

senior relaxes in hammock with e-book
Dividend Stocks

Generate $175/Month in Passive Income With a $30,000 Investment

Dividend aristocrats offer reliability, and many of them also offer generous yields. With sizable enough discounts, these yields can become…

Read more »

dividends can compound over time
Dividend Stocks

Best Dividend Stocks to Buy Now for Canadian Investors

These three stocks would be excellent additions to your portfolios, given their solid underlying businesses, consistent dividend growth, and healthy…

Read more »

data analyze research
Dividend Stocks

3 Undervalued Stocks to Watch in November

Not all undervalued and discounted stocks are destined or poised to make a comeback soon, and a protracted timeline can…

Read more »