Risk & return: Graham Witcomb Shares to avoid at all costs

If you want a good night’s sleep, here are three stocks that just aren’t worth owning at any price

Value investors tend to fall into one of two camps. The first is the “everything has a price” group. The second is where I stand – let’s call it the “sleep well at night” crowd. Don’t get me wrong – I want to achieve the best returns possible. But I don’t want to lie awake at night, fretting over the next management mishap or corporate bombshell just to earn an extra percentage point.

Below are three stocks we recommend you avoid – stocks with specific risks that mean we wouldn’t want to own them at any price.

In truth, there probably is a share price at which we would be happy to hold, or even buy, these stocks. But the market is unlikely to ever offer us that price because we think the downsides are underappreciated.

Qantas (ASX: QAN)

The trouble with our national airline has nothing to do with its customer service and a lot to do with its business model and industry. We’re unlikely to recommend any of Australia’s listed airlines any time soon.

Like most airlines, Qantas must contend with many factors beyond its control: huge fixed costs, volatile fuel prices, unionised labour, a capital-intensive business model, oligopolistic suppliers, competition from government-subsidised Middle Eastern and Asian airlines, and a fleet of other risks. The company’s $4.9 billion of debt provides no extra comfort, either.

What Qantas does have is a highly profitable loyalty program, with attractive economics. As earnings from this division grow as a proportion of total earnings, the quality of the business improves.

However, at Qantas’s current market capitalisation of $10.8 billion, the loyalty division accounts for less than a third of the stock’s value. It provides a floor to our valuation but with Qantas’s share price trading far above that floor we’re a long way from making an upgrade.

Aurizon (AZJ)

Australia’s largest rail freight operator, Aurizon, isn’t like most businesses. We won’t bore you with the details but the Queensland Competition Authority (QCA) caps the amount of revenue Aurizon can generate. The aim is to prevent it from using its monopoly position to set unfair prices. Essentially, the QCA dictates what return shareholders can earn.

This year the QCA drastically reduced Aurizon’s revenue allowance for 2018–21 to $3.9 billion. That’s $1 billion dollars below what the company said it would

As well, avoid absolutely everything related to medical marijuana

need to cover its costs. As things stand, Aurizon has a book value of $2.41 per share and the QCA only allows for that equity to earn a return of 6.99%. The QCA decision is still only a draft but it’s unlikely to be adjusted much higher.

If you require an 8% return on your investment, you’ll need to buy the stock at a 25% discount to book value. The current share price is about an 80% premium to it. Add to this the fact that half of Aurizon’s earnings are from hauling coal, iron ore and freight, all of which are exposed to the vagaries of the resource industry.

From one day to the next, Aurizon looks like a safe infrastructure stock. But its business model and today’s share price make it risky for long-term shareholders.

AMP (AMP)

To do well, wealth managers need one thing more than any other: trust. Whether you want to focus on AMP’s failed legal obligations and the fees that were charged when no work was done, or its lies to regulators and issues of governance, trust is lacking at every turn. The prospect of regulatory fines and – worse – a class-action lawsuit doesn’t fill us with confidence, either.

We expect that AMP’s tattered reputation will encourage advisers to leave the group. About 600 departed in 2017 and only 400 joined. We’re guessing that 2018 could be even more gruesome. That would ultimately reduce fund flows and assets under management.

We should also mention that net debt of $17 billion means interest expenses consume more than a quarter of operating profits, exposing AMP to rising interest rates and refinancing risk.

With a price-earnings ratio of about 12, the stock doesn’t look particularly expensive but the risks and downside overwhelm any case to buy.

When investing, you don’t have to do many things right to earn a decent return. But you do need to avoid train wrecks.

Other companies on our “avoid” list include Primary Health Care (PRY), Vocus (VOC) and WorleyParsons (WOR), as well as all aged-care providers, pharmacy stocks, agricultural companies, most specialty retailers and everything – absolutely everything – related to medical marijuana.

Graham Witcomb is a senior analyst at Intelligent Investor, part of InvestSMART Group (under AFSL 282288). This article contains general investment advice only. Find out more about Intelligent Investor and start a 15-day free trial at investsmart.com.au/money.