Sectors to Avoid

Warren Buffett has said the first rule of investment is not to lose money; the second rule is not to forget the first rule. And, with various sectors of the stockmarket flying high, we felt that our Investor’s College could usefully begin 2006 by focusing on both these rules.

The number one way to avoid losing money is to allow yourself a margin of safety. Yet there are areas of the market where stocks appear to be trading at premiums to a conservative assessment of their intrinsic value. Avoiding such stocks is probably the most important thing an investor can do to avoid a painful loss of lucre.

With this in mind, we’ve compiled a list of ways to lose your shirt in 2006. The fact a stock or industry has made our list doesn’t mean a fall is imminent; booms can last longer than anyone expects. But here are some areas where none of your analysts dare to tread, at least not at current prices.

OK, so we’ve been banging on about them for ages and, so far, we’ve been dead wrong. But steel companies are bad businesses and they’ll prove it eventually. They suffer from an almost unquenchable thirst for capital, a reliance on commodity prices, and a competitive environment that makes them price takers rather than price setters. Add to this a mind-boggling amount of capacity being added in China and we think the steel makers are in for a tough few years.

Although we might consider BlueScope, OneSteel or Sims Group at significant discounts to their net tangible assets (NTA), we wouldn’t touch them at current prices. Despite falls of 20% or more in recent months, there could be significantly more pain to come.

While stocks with great economics tend to give shareholders pleasant surprises, poor-quality businesses tend to serve up the other sort. The near halving in the share price of PaperlinX in a year from late 2004 is a case in point. And we still wouldn’t touch it.

But even more dangerous is a poor-quality stock that hasn’t fallen. Foster’s Group has added very significantly to its wine business by buying Southcorp, and this could shock unsuspecting investors at some stage. We’d also avoid cash-hungry airlines, so Qantas and Virgin Blue are off the list for now.

Despite enjoying its moment in the sun, Caltex is a business that has pretty average economics over the course of the cycle. Despite its association with the rare and fashionable black stuff, Caltex performs an industrial role. It processes crude oil and, while there can be occasional periods of margin expansion, over time it faces stiff competition. Comparing Caltex with the large integrated oil companies that both process and produce is like comparing Coca-Cola Amatil '” another stock we’d avoid at current prices '” with its American parent.

It’s not just poor economics that’ll do you in. Rinker is a business that we believe has pretty good economics. And it’s taken advantage of that fact to make a motza in the sun-belt states of the American south. But that part of America is undergoing a massive building boom based on an unprecedented borrowing frenzy, so Rinker’s profits are probably well above what it can expect to earn in "normal" times. Yet its share price is trading at 20 times current earnings. That doesn’t offer anything resembling a margin of safety.

West Australian Newspapers is a business with top-notch, though cyclical, economics. But management doesn’t seem to grasp the value of its main business, and is off doing questionable deals such as the purchase of a stake in Hoyts.

The domestically focused Boral also looks uninspiring. And Alesco is a conglomerate that owns numerous cyclical businesses. The stock isn’t cheap and could be whacked by any downturn.

Property trusts hold a special place in the hearts of income-focused investors. And most of the time we’d say they are perfect vehicles for those investors seeking safety and income. But property trusts have significantly underperformed the general market over the past year, and we wouldn’t be surprised to see that trend continuing.

They still trade at unsustainably high premiums to their underlying NTA. Backing overpriced, debt-laden property trusts at a time when their managers are greedily expanding offshore seems like a very bad idea to us. It’s the exact opposite of the "conservative investment" tag that property trusts have traditionally held.

This is one area where it’s always important to be cautious. Currently, uranium companies are the flavour of the month, but only time will tell which of these are profitable miners of dirt and which are profitable miners of investor gullibility. We expect the latter to significantly outnumber the former.

And what about those infrastructure funds that are able to use financial chicanery to pay dividends despite the fact that operating cash flow is many years away? Don’t be suckered by their marketing ploys. Remember: floats often take place because sellers can get a better price from an exuberant stockmarket than from more savvy trade or private equity buyers.

So there you have it. The stockmarket provides many more opportunities to lose a fortune than to gain one, so this list is far from complete. But if you make sure you give yourself a margin of safety, you’ll have every chance of making a decent return in 2006 and beyond.