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

Money Magazine Australia - - CONTENTS -

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.

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