Wednesday, October 17, 2012

Stocks Worth Avoiding?

In a previous article linked here I discussed some of the stocks that worked for my portfolio in the last quarter. Now I want to review some stocks and articles that I have been negative on.  I’m aware that some people cannot tolerate any slight perceived criticism over the stocks that they hold, but the mark of a good investor is that of someone who has the discipline to always stay objective when he (or she) is investing his hard earned money. So let’s use the Fool community to try to help each other become better investors.

Visions of China

The situation in China is concerning and I think the market is still too complacent about the risks here. Forgive me but I am a (partially reconstructed) free marketer. So while I can look at China and applaud the productivity improvements generated by shifting resources towards the the free market from collective control, I am also aware that it is still a communist country whose rulers are more interested in staying in power than anything else.

It is a country that weakens its exchange rate by printing its own currency and buying US Dollars. This can create local asset price bubbles. Let me put it this way, if you are flooding your markets with your own currency (in order to weaken it) and your populace doesn’t have a range of asset classes available to buy then is it any wonder that this money will end up local housing speculation?

I’ve been negative on the China related plays.

Stock Link Return Since Article
Joy Global JOY Link -28.8%
Caterpillar CAT Link -16.1%
Vale VALE Link -26.8%
Rio Tinto RIO Link -17.8%

Joy Global $JOY is in a difficult position right now and is being hit by a double whammy of US natural gas taking market share from coal in electricity generation and moderating growth in China’s fixed asset investment causing coal production to slow. In my opinion these are structural problems and won’t be resolved in the near term. Caterpillar is also exposed to heavy construction and its prospects will partly be determined by how China manages to stimulate fixed asset investment in future.

As for Vale and Rio Tinto $RIO, both these stocks are classic mining plays on global growth and emerging markets in particular. A lot of people miss the point that much of Brazil’s (and Russia’s for that matter) growth is dependent on supply China’s resource needs, so in a sense, Brazil is a play on China’s growth. Rio Tinto has probably outperformed the others thanks to its gold and silver operations but it’s not enough to cope with declines elsewhere.

An Ugly Quarter for Technology

Many tech names got beat up over the summer and I was no stranger to this with a couple of my stocks faring badly. Here are a few of the stocks I’ve written about and made negative conclusions over:

Stock Link Return Since Article
Facebook FB Link -35.5%
Hewlett-Packard HPQ Link -25.6%
Rackspace RAX Link  12.3%
Nokia NOK Link -27.4%

The standout is Rackspace $RAX, which has performed well, in line with the rest of the cloud computing sector. However, I still have doubts. Top line growth may well be very impressive but for the reasons articulated in the article I am cautious over the underlying cash flow. I’m not convinced that this business is scalable. Moreover the principle of outlaying substantive capital expenditures on gear with high depreciation rates for customers whose demand can wane in the short term is one that I am not comfortable with.

Facebook $FB has had a troubled start as a public company. There is a difference between liking a company or its service and liking it as an investment. Frankly, I ‘unlike’ analysts dropping estimates in the middle of an IPO. I unlike its prospects in dealing with the migration to mobile or that it went public without really outlining a clear pathway to generating revenues from mobile.  And above all, I unlike the fact that Zuckerberg seems to want carte blanche usage of users’ data and information and yet comes across as one of the most guarded CEO’s I have ever heard on a conference call. Of course if you don’t like it, there is a solution: Don’t buy the stock.

On a more consensual note, I think most people would agree that Hewlett-Packard $HPQ is facing some very difficult issues in its core markets of printing, pc’s and notebooks. It is also not a dominant player in storage and the Autonomy acquisition has disappointed and threatens to use up even more of the management resources. This is going to be a very tough turnaround for Meg Whitman to pull off. There is a huge amount of debt on the balance sheet and free cash flow declined in the last quarter. Its end markets are hugely competitive and it’s difficult to see what divestitures it could make that would attract healthy prices.

Nokia $NOK is another former tech champion fallen on hard times, but I confess I think the outcome could be happier here. It has a very strong balance sheet and a strong brand name in key emerging market economies. The challenge is to find a way to reduce operating income declines. Nokia’s balance sheet does give it some time on its side in order to restructure. For those who think that a takeover bid for the company is unlikely because a deal doesn’t make sense, I would point out that not all cash-flush IT CEO’s make sensible deals! I would also observe that it would fit very well with a Chinese company looking to buy market share and strip down the cost structure.

Value Outs Itself

One thing I’ve observed is that value based defensives seem to have done well in the markets despite little positive earnings news flow.

Stock Link Return Since Article
Kellogg K Link 1.7%
Campbell Soup Company CPB Link 8.7%

Kellogg  $K looks challenged by a weakening cereal category and from some poor execution issues. It is very hard for food companies to take pricing in developed markets in this environment; throw in rising prices for food stocks like corn and you have a perfect margin squeeze. Kellogg’s last quarter wasn’t particularly good and it guided lower than analyst estimates. However, the outlook appeared to get a bit clearer and the stock went higher. Right now, the market is rewarding good yielding stocks with perceivably stable earnings even if they are not performing particularly well.

It is a similar story with Campbell Soup Company $CPB, or even in technology with Cisco $CSCO, which is trying to morph into a value proposition.

There is a lesson to be learned here. Investors are very keen on yield in this environment, even if the companies paying it are not performing particularly well. Whether this will work going forward is open to question but an investor looking to diversify his portfolio and his investment style will take heed. Value will out itself.