Thanks, But No Thanks

With the market near record highs, there are plenty of stocks we wouldn’t touch with the proverbial barge pole. But these are the absolute last picks of our analysts.

On the subject of problem-solving, the mathematician Carl Jacobi advised: “Invert, always invert.” So, as a change from our usual occupation of hunting for sharemarket bargains, we decided to run through an exercise of thinking about the stocks we “wouldn’t buy for quids”. With a bit of luck, by spending a little time thinking about what we’d avoid, we might learn something more about the qualities we admire.

But we’d be lying if we said that was all there was to it. Bull markets can be frustrating affairs for value investors like us. Although we’ve been finding a steady supply of cheap stocks, the buzz just isn’t the same as it was back in early 2003 when the sale was in full swing. We pine for those days. So this exercise is born as much out of frustration as anything else.

So we asked each of our analysts to give us the one stock in the ASX Top 50 list that they wouldn’t dream of touching right now, with a brief explanation as to why. First, a caveat: these are not recommendations to “short sell” the stocks mentioned. There is an asymmetrical nature to the potential outcomes from buying stocks. If you’re wrong, the most you can lose is 100%; whereas if you’re right, the upside is limitless. That’s something we like to have on our side at all times, and it means we can be patient and sit with a situation that goes against us for as long as we like.

But when you short-sell a stock, that asymmetry is reversed: your losses are limitless and you can’t always afford to be patient with losing positions.

So these are simply the last stocks that would feature on our buy lists. But they find themselves there for a variety of reasons and, as you’ll see from the disclosure at the end, the reasoning isn’t always unanimous. The main purpose of this exercise is to understand the thought processes better and hopefully learn a little from them.

Tony Scenna
Three years ago, the board was full of bullseyes. Today it’s not, and winning is more about avoiding the losers. The practice of shorting or betting against a stock doesn’t fit comfortably with the way I invest. If I don’t like a business, I avoid it and find something else. Two stocks I wouldn’t touch today are Qantas and BlueScope Steel. Both operate in capital-intensive industries, highly exposed to commodity prices and with profits that are reminiscent of the rollercoaster rides at Luna Park. I would lean towards BlueScope Steel as the one to avoid, with the added bonus that chief executive Kirby Adams isn’t enough of a “super fast little fish” to make up for the business’s poor economics. (Tony is referring to a past BlueScope release in which the company is referred to as a small fish in the big pond of China, but a “super fast little fish”. For us, it was further confirmation of management’s unfounded belief in itself.)

Brad Newcombe
The stock I wouldn’t touch at the moment is James Hardie. The fibre cement business is a great one, especially overseas, but there are just too many red flags. First, the US property market has been booming for a few years and is due to come off the boil. Second, despite assurances from the company, I believe the asbestos situation is only going to get worse and the provision the company is making doesn’t give a true picture of how much cash will actually be paid out over the next 50 years. Finally, I don’t trust management and there is no point investing in a company unless you have confidence in the people running it.

Wayne Jones
We have been limited to the Top 50, but I believe far more pain is likely to occur in smaller companies with unsound balance sheets that offer only the promise of profits. The Top 50 is not my usual hunting ground, so I implemented a process of elimination in scrubbing companies that I felt confident would hold their own over the next few years, but this didn’t eliminate too many. So then I looked at price/earnings (P/E) multiples, but with resource companies so much of their profitability relies upon commodity prices that this method is fairly pointless.

As the value of my incremental analysis was virtually nil, I took a look at the short-sold positions, which are reported on the ASX site, and the answer is clear-cut, according to those who like to engage in this activity: Rio Tinto. Currently there are nine million shares short-sold, which represents more than 3% of Rio’s market capitalisation. Among the Top 50 companies, this was by far the highest percentage, with Aristocrat Leisure at 1.9% the next highest. I would follow Tom Elder’s lead and sell BHP Billiton before I would sell Rio Tinto, but the short-sellers are saying Rio. (Our recommendation on Rio Tinto remains Hold. '”Ed.)

Greg Hoffman
Charlie Munger again emphasised the importance of being able to destroy your own best-loved ideas at this year’s Wesco Financial annual meeting in Los Angeles. One idea I’ve destroyed over the past few months, with some generous help from an industry expert, is that it can never make sense to pay more than book value for an insurance company.

Even with this new-found appreciation, though, the current share price of insurer IAG looks pie in the sky to me. Many people are excited about IAG’s growth plans in Asia, but I’m mindful of the risks.

Australian companies have a strike rate well below 50% in terms of establishing successful international businesses. And I’m willing to bet that IAG will be home with its tail between its legs by the end of 2010. Add to that a domestic insurance cycle that’s past its peak and the likelihood of lower investment earnings, and I think the next few years are likely to be very unpleasant for owners of this stock.

Tom Elder
My pick is Newcrest Mining. At December 31, 2005, Newcrest was staggering under a $1.7 billion debt pile, much of which was acquired as a result of a massive investment in its flagship Telfer operation. The cash flow statement showed operating cash flow of $74 million (net of interest paid) in the six months to December 31. It will be interesting to see what happens when the lenders demand principal, let alone interest payments that are currently being capitalised.

Telfer is proving to be something of a technical challenge and, just to add insult to injury, one of the brains behind the redevelopment, Tony Palmer, has upped sticks and left. His replacement, Ian Smith, was poached from Rio Tinto and everyone is hoping he can weave some Rio operational magic on Telfer. But it will need more than a tweak. In a nutshell, the balance sheet is a mess; there are technical obstacles ahead; there’s a changing of the guard at the top; and the stock is neither cheap nor reasonable value on any measure. If the company does not get into real financial trouble, then massive writedowns will likely be a decent second prize.

Tim Searles
Top of the list for me is the banks, for a few reasons. I can’t see how future profit growth will be nearly as high as it has been in the past, due to higher interest rates, fewer cost savings, a struggling property market and growing competition. As a result, the banks are doing whatever they can to maintain growth, including reducing their lending standards. This is a huge red flag, which has even prompted a warning from the Reserve Bank. It’s like a dormant virus waiting patiently for an illness before striking. While the economy is healthy, there’s no obvious problem, but if it falters a lot of people will start defaulting on their loans and credit card debts.

As we saw in the early 1990s with Westpac, this can take a bank to the brink very quickly, and make a mockery of their “safe haven” status. Despite the bleak outlook and higher risk, the banks are collectively trading at valuations much higher than they’ve tended to in the past. If I had to choose one to avoid it would be Commonwealth Bank. (Our recommendation on all four big banks remains Hold. '”Ed.)

James Carlisle
I think the market places too much emphasis on the short term, so I tend to invest in companies that have good long-term prospects compared to what the market sees happening now. Here, I looked for the opposite and it was hard to see past BlueScope Steel.

With steel prices through the roof, BlueScope is producing some great numbers at the moment. The company is trumpeting a return on invested capital of about 20% and it made operating cash flow of $760 million in 2005. But two-thirds of that cash flow was eaten up by capital expenditure, which is a clue to what a tough business this is.

The company had negative free cash flow in both 2002 and 2003, and it made a loss in 2002. It may not be long before you see the same thing happening again. I wouldn’t touch it with a barge pole.

James Greenhalgh
Which Top 50 to avoid? My initial reaction was, 'easy, all of them’. I prefer dynamic, and invariably much cheaper, small companies; and the current crop of top stocks seems to be as unexciting '” and overpriced '” as you get. But narrowing it down to one, in the end, wasn’t overly difficult.

I only buy companies I understand, which tends to exclude miners, and in my view the sector looks overpriced anyway. So I looked for a resource company with high expectations, a poor record of profitability and high debt levels.

Using those criteria, the choice was clear: Newcrest Mining. Newcrest has an undeserved “scarcity premium” for being the largest Australian gold producer, and a negative $1.3 billion hedge book to boot, so there’s no way I’d buy it.

Steve Johnson
I’m going to risk upsetting one or two of my colleagues here, but the Top 50 stock I wouldn’t buy for quids (and if I inherited ownership I’d sell at the drop of a hat) is Fairfax. I’ve been uneasy about this business for a while and my recent trip to the Berkshire Hathaway annual meeting cemented my concerns. Not only are newspapers losing market share in the advertising industry, but the increased competition can only mean lower profits for the industry as a whole. Trying to solve the problem by paying ridiculous prices for new businesses is not a rational solution. I’ve come home with Buffett’s final say on the matter ringing in my ears: “It is difficult to pay a low enough multiple for a business in decline.”

Gareth Brown
I get to go last and, unfortunately, BlueScope Steel has already had the eyes picked out of it. But luckily there’s no shortage of stocks to steer clear of. In my moments of weakness, I’ll admit, I’ve considered shorting BlueScope. But I’d never consider short-selling Rinker, because it actually owns a pretty good business. But you wouldn’t even suggest it to your mother-in-law at these prices.

Rinker has ridden the boom of the American property market. If there is one “macro” trend I’m utterly convinced of, it’s that America is in for a hiding. Its economic “success” of recent years, fuelled entirely by debt, has been built almost exclusively on the expansion of McMansionland. High oil prices make the commute from the fringes of suburbia in your SUV prohibitive. And sky-high gas prices make heating and air-conditioning a huge, poorly designed home expensive. Yet they are selling at prices way above replacement cost.

The party can only last as long as the banks are prepared to make idiotic loans. I think house prices are due for a tumble and new development will grind to a halt at some stage '” as will Rinker’s cyclical bonanza. It is, however, a stock I might consider buying in any carnage that follows.

Disclosure: Contributors to this article own shares in Rio Tinto and Commonwealth Bank.