As much as I would encourage investors to focus on buying strong, attractive stocks, I would also highlight the importance of not overpaying for the right to own them. It is vital to remember that a great company does not always make for a good investment, and overpaying for them can not only destroy value but also overall wealth.
With the S&P/ASX 200 (INDEXASX: XJO) trading within 4% of a multi-year high, it goes without saying that there are a number of companies trading at excessive prices, but I believe the three below are standout examples right now…
Commonwealth Bank of Australia (ASX: CBA) has delivered investors some remarkable returns in recent years, in large part thanks to its exposure to Australia's booming housing market and its lucrative, fully-franked dividend. As strong as the company is however, the risks facing the business (and the industry as a whole) are far too great to warrant an investment in the bank right now, particularly given its excessive valuation.
To begin with, rising bad debt charges, intensified competition levels and the likely requirement to hold additional capital in reserve could all significantly impact earnings growth in the short-to-medium terms. In addition, should cracks begin to appear in the housing market, I believe Commonwealth Bank could be amongst the heaviest fallers.
Unlike Commonwealth Bank, Rio Tinto Limited (ASX: RIO) isn't overvalued right now but should be avoided given the headwinds facing the iron ore industry in which it operates. The price of iron ore has dropped more than 38% since the beginning of the year and is widely expected to continue tumbling over the coming months. More than 90% of Rio Tinto's earnings are derived from iron ore, so falling prices could seriously impact its margins. Although it will still remain profitable even at these lower prices, I believe patient investors will have the opportunity to buy the shares at an even better price than today.
Telstra Corporation Ltd (ASX: TLS) has plenty to offer investors. In addition to its juicy, fully franked dividend, it is also Australia's leading telecommunications company and is thus at the forefront to benefit from the growth of cloud computing and the 'internet of things'. But investors also need to be wary of the price they are paying. Although it has fallen in price in recent weeks, I don't believe it is a standout buy today.
