Investors are always on the lookout for a strong company at a great price, but it is worth looking at companies without sustainable competitive advantages that are trading at a premium to their fair value.

Today we highlight three shares that are trading in overvalued territory. And not just a little overvalued. All three of these shares are trading at over a 100% premium to our fair value estimate.

Shares trading at a significant premium to Morningstar’s fair value estimate are considered “overvalued”, while shares are trading well below their fair value estimate are considered “undervalued”.

This ratio—along with a company’s uncertainty rating—helps determine Morningstar’s overall star rating for a stock. The star rating provides a margin of safety for investors.

One- and two-star stocks are considered overvalued by Morningstar, while three stars means a stock is considered fairly valued, and four- and five-star stocks are considered undervalued.

By highlighting the overvalued stocks on this list, we hope to identify companies that could represent a significant price risk for investors at their current trading levels.

All data is current as of 25 March, 2024.

Reece (ASX: REH)

Business strategy

Reece operates two distinctly different business segments: Australia and New Zealand, or ANZ, and United States, or U.S.

Reece ANZ’s customers consist principally of independent, small, and medium plumbing businesses. These businesses are relatively price-inelastic, as costs are passed to the end consumer, and plumbers instead value parts availability and convenience, allowing them to complete their job quickly.

A secondary market is the Do-it-Yourself, or DIY customer. This consumer is generally price-sensitive, and Reece is not the cheapest in the home renovation space. Reece instead adds value with in-store expertise, given the complexity of range and product types. We think Reece is top of mind for DIY consumers, given the breadth of its network.

Reece has over 600 Australian stores, versus the next biggest competitor, Tradelink with around 200 stores. Bunnings has around 350 stores, but these are not plumbing-specific. Reece’s scale allows the ability to source an extensive range of inventory and the flexibility to efficiently allocate inventory between stores. We estimate it stocks more than any other plumbing retailer in Australia. Reece continues to gain market share in ANZ through new stores and growth in product segments including plumbing products for pools, irrigation, and fire protection.

Reece expanded to the U.S. in 2018 via the acquisition of the Morsco plumbing business, followed by smaller bolt-on acquisitions. We estimate it has low-single-digit market share in North America via about 250 stores. Earnings are mostly from commercial and residential construction. Reece intends to increase U.S. exposure to the repair and renovation market.

Although the U.S. stores have been profitable, we think the U.S. expansion has been value-destructive. In the five years prior to entering the U.S., ROIC including goodwill averaged 18% but has since halved. Investment in the U.S. appears set to persist. Management is currently focused on a rebrand and has increased its capital expenditure spending. We think more bolt-on acquisitions are likely as it attempts to gain market share and replicate the ANZ business model, which is predicated on a large store network.

Fair value

Our fair value estimate for Reece is $13.50 per share. About 75% of Reece ANZ’s earnings are exposed to the residential sector via new house builds, residential repairs, and renovations, or R&R. We expect cyclicality in the residential sector to weigh on revenue over fiscal 2024 and 2025. Thereafter, we forecast demand to return from fiscal 2026, driven by an undersupply of Australia’s existing housing stock, settling at about 200,000 new homes per year by the end of the decade.

In R&R, we expect a pull-back over fiscal 2024 and 2025 as households delay discretionary repairs and renovations in response to the high cost of living. We think Australia’s aging housing is driving demand for R&R over the long term and from fiscal 2026 through to our 2033 forecast horizon, we expect low to mid-single-digit growth. Additionally, we expect Reece will continue to capture market share in the fragmented trade business as it rolls out more stores and increases exposure to new products supporting plumbing for pools, irrigation, and fire protection. We forecast Reece ANZ to gain about 15% market share over the next decade.

Reece’s U.S. operations are principally exposed to commercial and residential construction. The repairs and renovations segment drives about one-fifth of U.S. segment earnings, and residential construction is about 40%, meaning total exposure to residential end-users is over half of segment earnings. We expect the threat of an economic recession, and high interest rates to weigh on near-term earnings due to a slowdown in construction. But we forecast a bounce back in residential construction from fiscal 2026, peaking at 1.5 million new starts, driven by an undersupply of housing and a lower cash rate. Thereafter we model new starts averaging 1.4 million per year over our 10-year forecast period. About 40% of Reece U.S. earnings is from the commercial construction segment, which loosely includes all modes of construction not related to the residential sector. We forecast U.S. commercial construction growth averaging low single digits over our forecast period, driven by economic stimulus and population growth.

We do not expect significant margin growth in either the ANZ or U.S. businesses over our 10-year forecast. ANZ’s earnings before interest, taxes, depreciation and amortisation (“EBITDA”) margins have been in the midteens for the past decade, and we think this is reasonable for a mature business. The U.S. has high-single-digit EBITDA margins, which are about 300 basis points below much larger competitor, narrow-moat Ferguson. The U.S. industry is fiercely competitive and highly fragmented, with many local, national, and independent plumbing retailers, suppressing margin growth. Additionally, the U.S. doesn’t have the same competitive advantages as it does in ANZ, which aid its high margins, including an established private-label range, a large store network, and centralized distribution centers.

Netwealth (ASX: NWL)

Business strategy

Netwealth provides investment administration software as a service. It includes portfolio administration, investment management tools, and investment and managed account services. The firm’s administrative capabilities encompass custodial and noncustodial assets.

Netwealth’s product integrates with external software, allowing it to facilitate more functions and streamline the implementation of financial advice to clients under a single—its own—platform. While Netwealth services all cohorts, it is particularly successful catering to more affluent clients who generate more revenue because of greater asset values and trading activity. This supports Netwealth's higher operating leverage relative to its peers.

Netwealth has exploited the bureaucracy and lethargy of the small number of dominant wealth management firms in Australia to develop a superior product and service. This has driven the group's rapid FUA grow in recent years. Netwealth has benefited from the Future of Financial Advice reforms, which had protocols like bans on conflicted remunerations or duty for advisors to act in clients’ best interests. The 2018 Hayne Royal Commission was another material tailwind. These events encouraged advisors to break from vertically integrated wealth management businesses, and seek new fee sources, including managed accounts, which were mainly available on independent platforms like Netwealth's.

We expect future competition among platforms to be more even, rather than skewed in favor of specialty firms like Netwealth. We believe Netwealth will continue gaining share, albeit slower than historically. It will keep benefiting from the post-Royal Commission popularity of independent platforms, but this trend will likely subside over time. Across the industry, players have evolved to comply with regulatory reforms and improved their products.

Netwealth remains relatively subscale to incumbent platforms and regulatory oversight is tight. As such, we don’t think the firm can win a price war, nor can it charge a premium for its services on a maintainable basis. Fee compression and continuing growth investments are likely to limit operating leverage.

Fair value

Our fair value estimate for Netwealth is $10.60 per share.

We project Netwealth to grow underlying net profit after tax at around 20% per year through to fiscal 2028. We expect this to be mainly supported by volume growth—new business wins and more revenue per customer, alongside mild improvements in operating margins with scale. We expect underlying EBITDA margins to average 55% per year over our forecast period, above its five-year average of 51%. We anticipate competition among platforms will even out moving forward, necessitating continuing investments to maintain revenue growth, which constrains operating margin expansion.

We expect Netwealth to grow its share of the investment platform market to about 14% by fiscal 2028, from around 7% currently. We forecast a 21% funds under management and administration, or FUMA, CAGR over our forecast period as Netwealth continues to win market share from a relatively low base. We forecast the ratio of platform revenue to average FUMA to decline to around 21 basis points by fiscal 2028, from 27 basis points in fiscal 2023. Despite higher transactional revenue (reflecting more trading activity from affluent clients), we project contractions in both the administration fee and platform cash margin due to competitive pressures.

We expect the balance sheet to remain debt-free for the foreseeable future. The decision by management to expense research and development costs also leads to very high return on invested capital, or ROIC. But the ROIC/WACC spread is not indicative of a maintainable competitive advantage in the capital-light platform industry that Netwealth operates in.

Polynovo (ASX: PNV)

Business strategy

Polynovo earns most of its revenue from US sales of its NovoSorb Biodegradable Temporizing Matrix, or NovoSorb BTM. The product is a patented biodegradable synthetic scaffold to support the regeneration of skin when lost through surgery, trauma, burns, or other causes of tissue loss.

Polynovo’s strategy revolves around expanding its geographical footprint to increase access to its products and open new hospital accounts. With its geographical reach the firm estimates its products are available to 800 million people as of fiscal 2023, but highlights the global market is underserved. The firm entered several new markets in fiscal 2023 including India, France, Spain, Canada, and Hong Kong, Polynovo intends to enter more geographies with new regulatory approvals, particularly with a focus on China and Japan through distribution partners. While the US market is key for Polynovo, representing roughly 80% of sales in fiscal 2023, new geographies would diversify the sales mix.

To support its organic top-line growth in existing and new markets, the firm invests heavily in expanding its sales staff as well as its in-house R&D. Product sales are largely through direct distribution, but Polynovo appointed distribution partners in select geographies including Germany, France, Spain, and Canada. Its R&D efforts center around exploring and receiving regulatory clearances for applications of NovoSorb products beyond the dermal substitute market.

Polynovo launched NovoSorb MTX in May 2023 to complement its main product NovoSorb BTM. NovoSorb MTX is like NovoSorb BTM but without the sealing membrane outer layer, and used in broader applications where it is not required. This is expected to drive sales with existing customers as sales staff can cross-sell products, with surgeons able to carry both products. Near-term, the firm is aiming to receive regulatory approval for full-thickness burns in the US and planning to complete recruitment of 120 patients for its associated US pivotal trial in fiscal 2024. The firm is also conducting clinical trials to receive reimbursement support for chronic diabetic foot ulcers and wounds. We think these efforts are likely to support growth.

We expect Polynovo’s NovoSorb products to pose a significant challenge to the traditional skin graft. We believe Polynovo will be successful based on the technology’s clinical performance and ease of use backed by a growing number of surgeon-led research and publications.

Fair value

Our fair value estimate for Polynovo is AUD 1.00 per share and assumes the company is profitable from fiscal 2024 onward.

We forecast a five-year group revenue compound annual growth rate (“CAGR”) of 25% forward to fiscal 2028 versus a trailing two-year revenue CAGR of 50%. This is driven by Polynovo’s key US geography where we forecast a five-year revenue CAGR of 21% for the region. We expect the firm increasing its sales staff to support market share gains.

In addition, we expect the recent product launch of NovoSorb MTX to increase penetration within existing hospital accounts given its broader applications. Our forecast five-year revenue CAGR for geographies outside the US is 39%. This is driven by recent entries in India, France, Spain, Canada, and Hong Kong, as well as planned entries into China and Japan. As such, we forecast revenue contribution from the US to drop to 66% of group sales in fiscal 2028 from 79% in fiscal 2023.

On the profitability front, we expect group midcycle operating margins to settle at around 35% by fiscal 2033. We forecast Polynovo’s maiden profit in fiscal 2024 and margin expansion from operating leverage. Our estimates deliver EPS growth of 18% at midcycle. We forecast average annual capital expenditures of roughly AUD 6 million over the next 10 years, or 3% of group sales. We also factor AUD 25 million in capital expenditure over fiscal 2025 and fiscal 2026 to fund a new manufacturing facility which has capacity to service an additional AUD 500 million in annual sales.