Five potential blue-chip blow-ups

These five major companies are currently underperforming and at risk.

Summary: Their operations span fertilisers, chemicals, mining, beverages and aviation, but these five companies have one thing in common. Various market signals point to underlying weakness, and all are likely to underperform on a range of levels.
Key take-out: Out of the five stocks identified, Qantas stands out – for all the wrong reasons.
Key beneficiaries: General investors. Category: Shares.

In previous articles I have written searching for underperformers in the ASX 50, the stocks mentioned within saw average underperformance of close to 5% over the two weeks from publication.

In this article I have again examined information in options markets, debt markets, short sellers, director transactions, analyst sell recommendations and index reweighting for signs of potential underperformance before overlaying quantitative trading strategies and my fundamental views.

The outcome is that Incitec (IPL), Orica (ORI), Newcrest, Coca-Cola Amatil (CCL) and Qantas are on my stocks watch list. A number of real-estate investment trusts also rated poorly, however I believe this was largely due to US Fed taper concerns and so these have not been included on this list.

The five stocks that show up currently at risk are:                                    

1. Incitec Pivot (IPL): Weak macro environment, overly optimistic earnings forecasts, poor shareholder returns and negative signs from short sellers and quant strategies has IPL on the list.

Quantitative Commentary:

  • The key longer-term issue seems to be mean reversion. Will EBITDA margins (currently around 19% and drifting lower) revert to the circa 10% levels of 2003-06, or will they reverse course and head back to the 20% levels of the last few years? Without a catalyst it’s hard to see why margins will improve.
  • IPL does not measure well on the earnings quality or debt fronts, leaving it pre-disposed to come up on my radar screen.
  • Short sellers have recently begun to build up positions in the stock. Overall short position levels are only slightly higher than average.
  • Valuation measures are mildly positive, but the key issue is whether current forecasts can be maintained.
  • IPL does not rate well on our quant strategies, with one of the lowest scores in the ASX 50.

2. Orica (ORI): Facing similar conditions to IPL, ORI looks cheap as long as you have confidence in the earnings … I don’t. Low P/Es can be “fixed” by a rising share price or by falling earnings.

Quantitative Commentary:

  • Earnings forecasts look optimistic – consensus forecasts have both sales and margin expansion in 2014 and 2015, despite a history of volatile earnings and a weak macro environment.
  • Earnings quality is not particularly high, and consensus forecasts have been in downgrade mode for the last five years.
  • Both short selling and option markets are flashing warning signals.
  • Valuation measures are positive. The key issue is whether current forecasts can be maintained.
  • Quant strategies are mixed. ORI looks good on valuation screens, average on earnings momentum and poor on price momentum.

3. Newcrest (NCM): NCM featured in the May edition of hunting for underperformers, and returns this week. NCM’s fundamentals have weakened, there have been big movements in the short selling market, and the valuation looks over-cooked.

Quantitative Commentary:

  • NCM featured in the first edition as a sell at much higher prices, and after a hiatus it’s back on the list of stocks to sell.
  • The key risk to this call is an improvement in its production issues.
  • Over recent years weakness in the gold price has led to gold stocks underperforming, but increases do not appear to have had a commensurate positive effect. This, plus production issues, means less faith in valuation measures.
  • The recent trends in both short selling and the options markets point to further concerns.
  • Return on equity has not been particularly good, and forecasts continue to suggest poor returns for shareholders.

4. Coca-Cola Amatil (CCL): Recent option and short selling action raises suspicions. My concerns over earnings quality, poor quant signals and poor earnings momentum were enough to put CCL on this list.

Quantitative Commentary:

  • CCL has been sitting on the verge of being included for some time. Its appearance this time is due to a range of factors from short sellers, options markers, insider share sales and analyst sell recommendations.
  • Earnings quality is also a little suspect. The last few years have seen a number of “inventory write-downs” given the benefit of the doubt by consensus analysts.
  • Reported earnings and dividends have been significantly above cash flows.
  • Quant signals are at odds with each other.

5. Qantas (QAN): A very poor return on capital record, poor earnings quality and poor interest cover: QAN is relying on a rebound in earnings to improve debt metrics.

Quantitative Commentary:

  • QAN scores so badly on most of our other measures that even mildly negative scores in key categories are enough to bring it into the spotlight for all the wrong reasons.
  • It’s hard to find a positive. QAN is consistently poor across almost all of our measures.
  • The balance sheet looks stretched and is relying on an earnings recovery to make debt metrics palatable.
  • Returns on capital are below average (at best).

NOTE TO RETAIL INVESTORS: This is a document prepared for institutional investors by our quantitative research staff. The recommendations are not targeted to a retail investor audience and may be inconsistent with fundamental research you receive from Wilson HTM.

This is an edited version of an article written on Monday September 30 by Damien Klassen and John Lockton of Wilson HTM Investment Group.

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