Given some of the conflicting signals earnings and data are showing, do the underlying fundamentals of the market support the big rally that we’ve seen? (The Morningstar US Market Index is up 17% so far in 2013.) For the most part, yes. But valuations across sectors and companies are starting to separate more, and security selection is becoming increasingly more important.

Some middling economic data last week, along with a benign inflation reading, added support to the notion that the Fed won’t have to tighten anytime soon. However, San Francisco Fed president John Williams’ comments Thursday, saying the central bank may back off from security purchases as early as this summer, reaffirmed that the Fed’s path is not set in stone. On the earnings front, a strong report from Cisco Systems  supports the theory that corporate America remains broadly healthy. Wal-Mart Stores‘  results on the other hand showed that the firm’s core consumers remain stressed even as Wal-Mart was able to maintain profitability.

The market’s rise hasn’t stressed valuations too much yet. Morningstar equity analysts think that the median price/fair value ratio for equities they cover is around 3% overvalued right now. That’s not a screaming bargain by any stretch of the imagination, but not in bubble territory either. However, valuations are far from even across sectors and individuals stocks. This is a big change from the recent past, where different parts of market moved in lockstep making it hard for large pockets of value to emerge. Now we have some sectors (such as consumer defensive and real estate) that are over 10% overvalued, while others like energy and basic materials are 10% undervalued.
Median Price/Fair Value by Sector


Energy


Basic Materials


Communication Services


Financial Services


Health Care


Technology


Consumer Cyclical


Utilities


Industrials


Consumer Defensive


Real Estate


Source:
Morningstar

As correlations fall, stock selection is becoming increasingly important. Investors can’t just buy indiscriminately and hope for the best. Instead individual stock buyers need to stay focused on buying high-quality firms with sustainable competitive advantages, or economic moats, that are trading enough below their intrinsic values to provide a margin of safety against unexpected company-specific or broader macroeconomic risks.

But sometimes (like now) there just aren’t that many incredibly cheap, high-quality firms on offer. So investors start to accept smaller margins of safety and pay up for quality. This is not a major mistake up to a point. Given the lack of opportunities available in cash or bonds, you can do a lot worse than buying a fairly valued quality stock. Investors do, however, need to be extremely vigilant to make sure they are in fact paying a fair price and aren’t buying a company that lacks competitive staying power. A big part of success can be avoiding stocks that are trading at a big premium, that have a lot of uncertainty surrounding their prospects, or that could quickly come under pressure.

We used Morningstar’s Premium Stock Screener to find these stocks to avoid. We screened for shares that had Morningstar Ratings for stocks of 1 or 2 stars, that had no economic moats, and that had a fair value uncertainty rating of at least high. You can run the screen for  yourself here. Below are three names that passed.

HCA Holdings     
| Fair Value Uncertainty: Very High
 
From the Premium Analyst Report:
HCA’s 2011 IPO provided an exit strategy for private equity investors in one of the largest leveraged-buyouts in history, valued at $33 billion in 2006. HCA’s private owners boosted profitability and free cash flow by selling underperforming assets, controlling costs, cutting capital expenditures, and focusing on higher-margin outpatient services. Although the company has cleaned up its act, we consider recent performance unsustainable. Thanks also to the firm’s high financial leverage, we would require a large margin of safety before considering an investment in HCA.

Plum Creek    
| Fair Value Uncertainty: High
   
From the Premium Analyst Report:
With only a small manufacturing business to speak of, Plum Creek’s value unquestionably resides in its timberland holdings, which comprise 6.4 million acres throughout the U.S. Judged solely by log harvest profits, Plum Creek’s timberland isn’t especially valuable. We estimate the company’s holdings generated average EBITDA of $36 per acre from 2004 through 2012, quite a bit lower than our estimates for timber REIT peers Rayonier ($54 per acre) and
Weyerhaeuser ($78 per acre). Geographical distinctions account for the differences among the three. In Plum Creek’s case, an “overweight” position in the less productive tree-growing regions of the country explains its lower “per acre” profits.

Under Armour    
| Fair Value Uncertainty: High  
 
From the Premium Analyst Report:
As a leading innovator of performance apparel, we believe Under Armour is well on its way to establishing itself as a global athletic brand. Consumers have shown great affinity for the label across multiple product categories, and retailers have been more than happy to give Under Armour shelf space and reduce their dependence on Nike . While we believe Under Armour will continue to grow, entry into additional categories, such as footwear, have shown some uneven growth, although continued gains in the core domestic apparel business has outpaced expectations. In the highly competitive sporting goods industry, especially in footwear, we find well-entrenched rivals, and footwear, because of both consumer loyalty and great economies of scale, tends to be a more concentrated industry segment. Some footwear makers are specialists, such as Saucony, or Brooks in running, while others evoke high brand loyalty, such as Nike in basketball, or have competitive advantages due to scale and global reach, such as and Mizuno.

All data as of May 17.