Everyone Loves These Stocks — That’s Why You Should Avoid Them

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Wall Street analysts still get a bad rap for cheerleading stocks that their bankers favor.

So it’s refreshing when they come out with the rare critical look at the stock market and suggest stocks you might want to avoid. Credit Suisse takes a stab at this every quarter in a report that will delight any contrarian.

The bank highlights “crowded trades,” or companies that are so favored by mutual fund managers and Wall Street analysts that they look like trouble.

These quarterly reports, called “The Darlings of Active Managers” and “Carving Up the Consensus,” aren’t predictions that overcrowded sectors and stocks are about to crash. Instead, they’re names and groups that are more vulnerable to weakness because everyone loves them.

The logic here is twofold. First, if everyone loves these stocks, who is left to buy them? And if they are priced to perfection, then just a little bad news might get a stampede going. Selling can beget selling, as the herd heads for the exits.

Credit Suisse says its research has a decent record of predicting underperformance, and it works best on crowded trades in the large-cap and growth categories.

Who doesn’t like a winner?

Since bullish crowds push stocks higher and this draws in even more investors who want to run with the bulls, it’s no surprise that the most crowded trades are usually the stocks that have performed the best. “The bias is that the recent past will repeat itself near term,” says Eric Marshall, director of research at Hodges Capital Management.

But the problem is that most of the potential profits have already been made in darling stocks, since they turn into crowded trades. “The best company in the world isn’t a great investment if everyone thinks it is the best company in the world,” says Marshall. Instead, stocks that offer the greatest opportunities are the ones that no one is talking about, he says.

That’s how contrarians think. But people, being people, they often love to be with the crowd. So they pile into popular trades even if it’s not the best way to make money.

Here are some of the most popular sectors and stocks today, according to Credit Suisse, which you may want to think twice about owning.

“We recommend against owning too many of these names,” says Credit Suisse chief U.S. equity strategist Lori Calvasina.

Chips

Investors are enthralled with semiconductor companies for two main reasons, says Heartland Advisors portfolio manager Colin McWey. One is the belief that wickedly volatile sales and inventory cycles have miraculously smoothed out. The other is a spate of mergers and acquisitions. This M&A is supposedly a plus because of “synergies,” cost cutting and cross-selling opportunities they bring. “It seems like folks have really gotten behind the consolation,” says McWey.

Buy-side bullishness is already a problem, but there’s more to the story. Sentiment is actually beginning to slip among portfolio managers. This could auger the beginning of a downtrend. “All of our buy-side indicators have plenty of room to retreat before reaching oversold conditions,” says Calvasina.

There are more troubling signs on the sell side, because Wall Street analysts are on board in a big way. They have the highest percentage of “buy” ratings on chip stocks in years.

“This indicator may be ripe for reversion,” says Calvasina.

What might amp up the negativity among investors? Any sign that swings in demand and inventories are not really a thing of the past would be a big problem. This really shouldn’t be a surprise if it happens.

“Ultimately these are still very cyclical businesses,” says McWey. Next, negativity could develop if investors see signs that the hoped-for gains from mergers aren’t panning out. This could easily happen too. “Historically, companies have a mixed track record with M&A,” says McWey.

Credit Suisse says particularly crowded trades include Intel INTC, Qualcomm QCOM,  MKS Instruments MKSI,  Microsemi MSCC, Monolithic Power Systems MPWR, and Lam Research LRCX.

Software services

In a world short on growth, investors have crowded into the few sectors that display any. Companies that offer software and software-related services fit the bill. “These stocks have been priced to perfection because of their above-average growth in the past five years,” says Marshall, at Hodges Capital Management. “This is an area where we are underweight. We have a hard time getting comfortable with the valuations.”

Alarmingly, both hedge-fund ownership and bullish sell-side ratings have reached historical highs, says Credit Suisse.

To help justify bullish ratings, sell-side analysts have resorted to an old trick from the tech-bubble era. They’re valuing companies on the basis of price-to-sales. This can be a useful measure for young companies that have minimal earnings, because scant earnings make price-to-earnings multiples meaninglessly high. “But it’s less appropriate for mature companies because you can’t use sales to pay dividends, buy back stock or make investments,” says Marshall. For that, you need earnings.

The use of less conventional valuation tools like price-to-sales to rationalize bullish ratings works, until it doesn’t. “When something goes wrong, it’s kind of hard to find a floor because there’s no earnings or free cash flow floor underneath to support valuations,” says McWey. “And you never know when the rug is going to get pulled.”

On the flip side, because valuations are high, it’s not easy to justify owning those stocks.

“It’s really hard to see how these companies can be valued much higher than they are today,” says Brian Frank, portfolio manager at Frank Capital Partners, who sold his position in Microsoft MSFT, -0.01% in the fourth quarter. “I don’t think Microsoft is going to have a disaster. It’s a really great company. But it is fully valued.”

However, many less substantial tech companies are so priced to perfection that “any little disappointment could result in significant downside,” he cautions.

Credit Suisse cites Microsoft as a crowded trade. It is an overweight position in nearly half of S&P 500 benchmarked funds. Others include: Alphabet GOOG, -0.01%Facebook FB, +0.05% Salesforce.com CRM, +0.02% Adobe ADBE, +0.45% VantivVNTV, -0.12% Take-Two Interactive Software TTWO, +0.13% Electronic ArtsEA, +0.01% Fiserv FISV, +0.15% ServiceNow NOW, -0.01% Guidewire SoftwareGWRE, +1.42% CoStar CSGP, -0.47% Proofpoint PFPT, +0.46% Fidelity National Information Services FIS, +0.01% and Red Hat RHT, +0.17%

Netflix NFLX, +0.11% arguably a software-services company, is the only FANG stock (Facebook, Amazon, Netflix and Google) that doesn’t appear on the overcrowded trade list.

Technology hardware

In a sluggish economy, investors have crowded into tech-hardware companies because they are among the few with decent growth.

Here are some warning signs from Credit Suisse on this group that should grab your attention. The share of bullish sell-side ratings is at the highest level in over 15 years. Hedge-fund ownership is at all-time highs. And mutual fund exposure has been rising.

Tech-hardware companies that look like crowded trades include Apple AAPL, -0.03%Cisco CSCO, -0.06% Western Digital WDC, +0.58% and Amphenol APH, -0.01%

Consumer staples

In a world of lousy returns from bonds because interest rates are so low, investors have turned to the stock market for bond substitutes. They’ve found them in consumer-staples companies that pay decent dividends and offer the potential for capital appreciation.

The problem here is investors have driven these shares to valuations that are too high, given their relatively meager sales and earnings growth potential. “I sincerely doubt they will be able to grow earnings in alignment with their P/E ratios,” says McWey.

But that’s not the only issue. Blinded by their love of dividends, investors have taken their eyes off potential risks. Competition in the grocery arena is fierce. A company like PepsiCo PEP, +0.01% can get hit by changes in consumer tastes.

And input costs could go up a lot, crimping margins. “Add that into a very combustible mix of high valuations, and you could see significant declines even without a recession or a decrease in revenue growth,” says Frank, at Frank Capital Partners.

Despite these risks, the number of mutual funds overweight in large-cap companies in food and staples retailing was recently hitting new highs, says Credit Suisse. The percentage of sell-side analysts with bullish ratings was also near highs for the past 15 years.

Besides Pepsi, consumer-staples companies that look like crowded trades include Newell Brands ( NWL, -0.02% CVS Health CVS, +0.01% and Costco WholesaleCOST, +0.20%

Enjoy their products if you want. But be careful with their stocks, particularly if you’re thinking they might serve as a defense for your portfolio in a selloff. They probably won’t, especially if that selloff is sparked by rising interest rates, a likely scenario, because this hurts bonds and bond proxies like consumer-staples stocks.

At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush has suggested INTC, QCOM, GOOGL, FB and NFLX in his stock newsletter, Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist group, and he attended Columbia Business School in the Knight-Bagehot program.

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