The Bad And The Ugly
Most of the stories printed in Dow Theory Forecasts offer advice about how to analyze stocks or recommendations of specific stocks to buy. This one is different.
Today we discuss shares of companies in such bad shape that you should avoid them. They have done just what their Underperform rating implies. Since we started using the Underperform rating in April 2002, an equal-weighted portfolio containing just our Underperforms would have fallen 43.2%, versus a 16.4% decline for the S&P 1500 Index.
The table below lists 12 stocks on our Monitored List with Quadrix® Overall scores of 20 or lower. Of those companies, just four earn Underperform ratings. Why don’t we award Underperform ratings to more of the ugliest stocks? Read on to find out.
Not surprisingly, many of the stocks with the weakest fundamentals are financials, dragged down by poor growth and eroding earnings estimates. Most low-scoring stocks have genuinely poor operating momentum, but we are reluctant to assign Underperform ratings for two reasons:
• The federal government’s bailout and other policies make handicapping financial stocks’ performance more difficult. Many financials have surged in recent weeks — not because their outlook has improved, but because of positive news out of Washington. Our system of quantitative and fundamental analysis cannot handicap such government action.
• Troubled stocks don’t always have to knock the cover off the ball to tack on gains. Many of the weakest companies — particularly financials — have been so badly pounded that even a glimmer of good news could lift the shares before the statistics considered by the Quadrix stock-rating system show improvement.
In general, the Forecasts recommends against selling stocks short, and not solely because of the two issues discussed above. The innate volatility and unpredictability of the weakest stocks, coupled with the stock market’s long-run upward trend, makes betting on a downward move risky. When we rate a stock Underperform, we are advising that you avoid it, not that you bet it will decline.
In the following paragraphs, we review some of the market’s uglier names.
This week, we bestow the dubious honor of an Underperform rating on Alcoa ($9; AA), which produces aluminum and a raw material used to make it. Sales of aluminum in the U.S. are likely to decline this year, just as they did in 2008. Aluminum prices are down more than 50% from June highs, and the combination of weak demand and ample supply should keep prices low.
Blame much of that weakness on two key end markets, residential construction and automobiles, with little chance for quick turnarounds. Despite a consistent decline in profit estimates, Alcoa has missed per-share earnings projections in the last three quarters. Alcoa is being downgraded to Underperform.
Ford Motor ($5; F) has tried to distance itself from its weaker rivals, and the stock has rebounded 119% this year. Overall, Ford has dealt with adversity better than the other two U.S. automakers, swapping debt for equity and apparently not touching its line of credit from the federal government. Ford raised another $1.4 billion by issuing 300 million common shares. While the company’s ability to raise capital is a positive, the stock offering dilutes the share base by 10%.
Ford still looks sick, with the recession aggravating chronic ailments. Ford has posted per-share losses in each of the last three years, and Wall Street expects per-share losses of $2.44 in 2009 and $0.39 in 2010. Persistent weakness in the automobile market is not helping matters. Ford’s 2009 sales have fallen 40% through April, compared to an industrywide decline of 37%. Ford remains an Underperform.
Options for General Motors ($1; GM) are dwindling as it nears a June 1 deadline to prove itself viable. The stock has plunged to a 76-year low, and it seems overvalued even at this price. Six top GM executives apparently think so as well — they have unloaded all their shares.
GM has proposed issuing up to 60 billion shares to pay off the federal government, the United Auto Workers union, and bondholders. Given GM’s current share count of about 610 million, the plan would give current shareholders just 1% of the company. Exacerbating the company’s woes, GM has yet to reach a stock-swap agreement with bondholders who have balked at exchanging their $27 billion claim for a 10% equity stake, currently valued at about $70 million. Bankruptcy appears likely. GM is an Underperform.
Low scorers take lead, but don't buy them
We derive Quadrix scores from dozens of statistics, and a poor Overall score generally indicates a stock has weak fundamentals. Such stocks tend to make poor investments — low Overall scorers have lagged the broader market by a substantial margin over the last 15 years.
Companies with weak fundamentals sometimes lead the market up during rallies. We have seen that phenomenon this year. However, such stocks rarely have the strength to sustain a rally.
Since March 11, a couple days after the S&P 500 Index hit its lowest point of the year, the lowest-scoring quintile of the S&P 1500 Index has gained 52%, better than the gain for any other quintile. However, the weak long-term returns of low-rated stocks suggests those gains will not last.