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4 Red-Flag Stocks to Sell This Summer - views
BALTIMORE (Stockpickr) -- Is your portfolio waving red flags at you?
Too often, investors miss out on major red flags until it's too late -- but with the benefit of hindsight, a pattern of deteriorating financials typically isn't hard to spot in a stock that's taken a significant dive. The challenge, then, is to know what to look for before your shares get shellacked.
That's becoming even more important as we get further into the summer. Historically, summer is a period of comparatively poor equity market performance, a fact that we're now seeing this year with the end of 2013's primary uptrend in June. A weakening stock can get buoyed higher by indiscriminate buyers in a bull market, but that doesn't carry over when the bears come out. When the broad market's in a downtrend, deteriorating firms are all but guaranteed to get sold off hard.
Today, we'll attempt to spot the red flags in four big names before that happens.
We're looking at a combination of highfalutin metrics that point to money problems for companies. To make our list, a stock has to has to meet three out of these four red flag criteria: a bankruptcy prediction formula called Altman's Z-Score that registers at less than 1.8 (that indicates financial distress); rising CDS spreads, indicating that institutional investors are pricing in a higher probability of bond default; and dropping sales and inventory turnover.
That quantitative approach to finding out red flags avoids the bullish bias that's historically put blinders on investors. So, without further ado, here's a look at four red flag names to sell this summer.
Clorox (CLX) may seem like a surprising name to see on this list. The $11 billion company is a stalwart in the consumer staples sector -- it owns a stable of brands that includes Glad, Hidden Valley and Brita, in addition to the firm's household-name bleach products. Now, I'll be the first to say that Clorox isn't exactly in risk of default -- but it is at risk of price downside right now.
That's because Clorox hasn't justified the growth premium on its earnings in 2013. After taking part in a six-month rally that favored consumer names above all others, the firm boasts a P/E ratio of nearly 20 but sales effectively remain stagnant over the last few years. Clorox does have a nicely diversified income statement, but a defensive posture doesn't warrant a growth-stock price tag. Right now, Clorox's dividend eats up 71% of its free cash flows, which doesn't leave much room for debt extinguishment. Lengthening inventory and sales turnover suggests that sales are slowing and it's taking longer for Clorox to collect on its invoices.
And while Clorox has a strong credit rating now, a minor downgrade could push it into territory that some portfolio managers can't touch by mandate -- a factor that would increase Clorox's cost of capital. The lack of meaningful growth is a real problem at a time when bigger rivals are making headway overseas. While this stock is far from financial distress, it's becoming expensive this summer, and it's not the defensive name that most investors think it is.
It's been a pretty poor year for PHH (PHH). While the S&P 500 has rallied more than 13% year-to-date, PHH has actually managed to fall almost 10% since the calendar flipped over to January. That's 23% underperformance for those keeping score. But PHH isn't done throwing up red flags this summer.
PHH has two main businesses: It originates mortgages, and it manages commercial vehicle fleets for other businesses, with more than 580,000 vehicles under its coverage. Those businesses couldn't really be much more different -- but they're at least both tied in a perverse way to the credit cycle. Cheap money has fueled improvements in PHH's fleet unit, offsetting some of the losses from the firm's mortgage servicing business. Mortgage originations are PHH's bread and butter -- and while they've recovered in this loose credit environment, the fast-rising mortgage rates of the last couple of months could create a hurdle for earnings.
PHH has a hefty cash balance -- almost $1 billion in cash sits in the firm's coffers right now. But that effectively means that the entire business is being valued at close to zero by Wall Street right now. Investors have a hefty (and risky) loan book to thank for that. Either PHH is the bargain name of the year, or it carries considerable downside risk right now. PHH's high level of financial leverage could erode its cash balance quickly if economic conditions deteriorate.
Fertilizer maker Mosaic (MOS) is another red flag stock to avoid right now. Mosaic is one of the biggest phosphate and potash producers in the world, supplying farmers with bulk crop nutrients -- the firm owns approximately 12% of the global market for each nutrient. Commodity risks are sky-high for Mosaic and its peers, particularly now that high soft commodity prices have had a few years to sink in. Profitability could get hammered lower by any combination of increased nutrient production by new rivals or falling prices for the soft commodities that its customers grow.
Like Clorox, Mosaic doesn't face the risks of a deteriorating financial situation. The firm, after all, enjoys a fortress-like balance sheet, with more than $3.8 billion in cash offsetting a mere $1 billion debt load. But macro risks are real right now -- especially as the threats of deflation rear their head at the same time that the Fed is threatening to cut off the flow of stimulus cash. BLS data show deflation in the trailing two months -- and year-to-date inflation in 2013 at a 53-year low. That suggests that the dollar is gaining ground on commodities, a fact that dilutes earnings for a company such as MOS that earns revenues indexed off of commodity prices, not dollars.
Mosaic's financial wherewithal effectively guarantees that the firm can weather any economic challenges in the intermediate term, but that doesn't guarantee it won't destroy shareholder value. Caveat emptor.
Last up is SBA Communications (SBAC), a red flag stock that investors already hate. As I write, the firm's short-interest ratio weighs in at 10.2; that means that it would take more than two weeks of buying pressure for shorts to exit their bearish bets. Even though large-caps with high short interest statistically tend to outperform the market long-term, that's not the same as saying every heavily shorted large-cap will outperform. Sometimes, shorts are piled in against a stock because it's damaged goods.
SBA is one of the biggest independent cellular infrastructure firms in the world, with thousands of cell towers spread across North, Central and South America. That's attractive positioning, generally speaking: The cellular infrastructure business enjoys high demand as more and more users upgrade their mobile data needs. But SBAC's capital structure makes it difficult to keep its head above water -- and the firm hasn't been profitable in recent memory.
A hefty debt load translates into hefty cash obligations each quarter. And while SBAC meets those cash needs, it's doing so at the expense of shareholder value. Not surprisingly, this stock has underperformed the broad market by a wide margin in 2013. It makes sense to keep avoiding this stock right now.
To see these stocks in action, check out the at Red Flag Stocks 2013 portfolio on Stockpickr.
-- Written by Jonas Elmerraji in Baltimore.
At the time of publication, author had no positions in stocks mentioned.
Jonas Elmerraji, CMT, is a senior market analyst at Agora Financial in Baltimore and a contributor to TheStreet. Before that, he managed a portfolio of stocks for an investment advisory returned 15% in 2008. He has been featured in Forbes , Investor's Business Daily, and on CNBC.com. Jonas holds a degree in financial economics from UMBC and the Chartered Market Technician designation.
Follow Jonas on Twitter @JonasElmerraji