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.

In a recent article we highlighted investor darling and narrow moat rated Pro Medicus which our analysts believe is trading significantly higher than our fair value.

Today we highlight three shares that are also trading in overvalued territory.

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 October 10, 2023.

JB Hi Fi Ltd (ASX: JBH)

Shoppers are prioritizing food and drink over nice-to-haves and JB Hi Fi is currently trading in two-star territory at 24% above our fair value estimate of $36.50.

Morningstar Director of Equity Research Johannes Faul expects only modest discretionary goods sales growth in fiscal 2024, while interest rates stay high and household incomes struggle to keep up with inflation. With demand soft, discounts and promotions abound in discretionary retail, and with wages rising as well, earnings are under pressure.

Faul does not believe that JB Hi-Fi has an economic moat. The Australian discount electrical retailer has over 300 JB Hi-Fi and The Good Guys branded stores across Australia and New Zealand. The stores are typically relatively small in size and located in high-foot-traffic areas. The brand has resonated well among consumers as a differentiated youthful brand offering value and convenience. However, competitors have realigned their strategy to offer similar levels of discounts and store appeal. The demise of Dick Smith has removed a competitor in the near term, but we expect competition in electronics retailing to remain significant.

Online retailers operate within an environment of very low operating costs, with technology providing a 24-hour shopfront and no need for expensive shop leases or selling staff. The lower operating cost enables these new market entrants to deliver products at a compelling price and offset JB Hi-Fi's scale advantage, in our view. JB Hi-Fi’s offering is also not differentiated enough to justify selling products at a premium retail price. The company competes on a global stage in online, with the distinct disadvantage of corralling a domestic population of around 25 million, compared with those from the U.S., servicing more than 330 million.

Fortescue Metals Group (ASX: FMG)

Commodity prices in the mining sector are supportive but Fortescue is still trading in two-star territory at 38% above our fair value estimate of $15.

Commodity prices have generally stabilized after falling on concerns that China’s reopening would underwhelm, along with worries over a recession in the West. Even so, they remain elevated versus history and cost-curve support. Miners’ earnings and margins are under pressure from increasing labour, fuel, logistics, and other expenses, though inflation looks to be moderating.

Morningstar Equity Analyst Jon Mills believes Fortescue is poorly positioned compared to peers. The company faces very high systematic risk, specifically Fortescue's lower margins relative to industry leaders BHP, Rio Tinto, and Vale, and somewhat higher debt levels relative to peers.

Mills assigns Fortescue a no-moat rating. The iron ore produced by its mines generally has less iron content than the 62% iron ore benchmark while also having higher percentages of impurities such as sulphur, alumina and phosphorous.

As a result, Fortescue’s iron ore is lower quality than that produced by its major competitors such as BHP, Rio Tinto and Vale. This competitive disadvantage results in its iron ore tending to sell at a material discount to the 62% benchmark price, with the average discount over the 10 years to fiscal 2021 being about 25%.

Coles Group Ltd (ASX: COL)

Coles Group is trading in two-star territory at 7% above our fair value estimate of $14.50.
This is not to say there are not positives about the business. Coles Group's businesses are defensive in nature, with its cash flow largely from consumer staples which are relatively stable across the economic cycle. Coles also profits from negative working capital, allowing it to release capital as the business scales.

Despite near-term strengths in its competitive positioning, Morningstar Director of Equity Research Johannes Faul thinks Coles lacks an economic moat. The group has cost advantages over smaller competitors due to its significant scale, and the difficult-to-replicate store locations of its Coles supermarket and liquor businesses, which account for over 90% of operating income.

However, the step-up in competitive intensity introduced to the Australian supermarket industry by Aldi is unlikely to abate. While Faul expects the near- and medium-term impact on Coles' market share and EBIT margins to be muted, increasing competition longer term could force industry EBIT margins structurally lower. Amazon Australia has already ramped up its pantry category in Australia, and Amazon Fresh poses a threat to Coles' high-growth online channel, but also core in-store sales.

Should investors sell overvalued shares?

Not necessarily. At Morningstar we believe there are significant advantages to long-term investing. Continual trading can lead to poor outcomes by increasing transaction costs and higher taxes.

However, we also encourage investors to focus on the long-term advantages of purchasing companies with sustainable competitive advantages or moats. Owning companies that can successfully hold competitors at bay will enable higher margins and higher returns on capital invested to expand the business.