Avoid investing in these stocks and sectors

Investors are often told to keep an updated “shopping list” of the stocks they are interested in purchasing. The idea is that you should thoroughly research each company, understand its businesses, and have a “buy price” where you’d be willing to invest in that company.

This is good advice.

However, I think it’s even MORE important for investors to have a “not interested” list. This is a list of companies and sectors that you’re just not interested in investing in.

I try to spend at least as much time adding stocks and sectors to my “not interested” list as I spend adding names to my shopping list. I figure this saves me quite a bit of time, because once a company is on my “not interested list” I can just ignore it for 5 or 10 years. If I see an article talking about a company or sector on my list I can just turn the page (literally or figuratively) and move on to something else.

One note – my “not interested” list doesn’t necessarily mean that these stocks or sectors can’t make you money. It doesn’t even mean that these companies are bad investments. After all, any stock can be a good investment at the right price.

And just because a sector is on my “not interested” list doesn’t mean that every company in that sector is a poor investment. There are absolutely some stocks in terrible sectors that do well (Southwest Airlines in the airline industry, for example).

But the great thing is that you don’t need to be an expert on every publicly traded stock in order to be a great investor. You don’t need to find 100 companies to invest in – at any given time you only need to find one company to invest in.

If you don’t like the industry, or don’t understand the business, or just don’t like the company then just put it on the “not interested” list and move on. And if you can’t find interesting to invest in, then you can just hold cash.

Here are some examples of the companies and sectors that I avoid, regardless of the price:

Companies with high fixed costs and/or ongoing capital investments

This category includes any company that needs to invest large amounts of money in order to provide their core product or service.

Examples:
– Airlines: United, Delta, etc.
– Cruise ship operators: Carnival Cruises, Norwegian, etc.
– Telecom: AT&T, Verizon, etc.

The upsides to a capital intensive business are that the high fixed costs act as a natural barrier to entry. If a competitor wanted to enter into the cruise ship business they’d need to be prepared to make an investment on the order of billions of dollars to acquire the ships, negotiate long-term cruise terminal contracts, etc.

Here’s the way I look at high fixed costs – if you have a business with $10 in costs (and let’s assume they are all fixed costs), and $15 in revenue, then you’d normally make a profit of $5. However, if something (like a global economic slowdown due to a pandemic) causes revenue to fall to $0 for a quarter, then your business loses $10. If you don’t have $10 in cash then you have the potential to go bankrupt.

However, if you have a business with $10 in variable costs and $15 in revenue then you normally make the same $5 of profit as in the first case. However, if there’s a downturn in the economy and your revenue goes to $0 then you can reduce you variable costs (let’s say by 50%) and you only lose $5.

Ultimately, high fixed costs make it more likely that a business will “blow up” during a downturn. This is when a company goes from profitable to bankrupt seemingly overnight.

Companies with short term spikes due to recent news and events

This category includes companies who are expected to benefit in the short term due to disruptions from the COVID-19 pandemic.

Examples:
Stock: Clorox (CLX)
Stock: Costco (COST)

Clorox is getting a boost because there’s been a spike in the usage of Clorox wipes and other cleaning products.

Costco’s business seems to have actually improved as a result of COVID-19 as consumers scramble to stock up on groceries and household supplies. Our local Costco has had hour-long lines to get inside, and as of 2 weeks ago they were completely sold out of all paper products.

The problem with investing based on short term trends like these is that investors almost always overreact. For example, I decided to dig into Clorox’s balance sheet and annual report to see if the company’s massive recent outperformance was warranted.

Here’s a slide from Clorox’s 2019 annual report:

We see that the Homecare segment (which contains Clorox wipes and other consumer sanitation/cleaning products) is just 19% of Clorox’s sales. The whole cleaning segment (homeware, laundry, and professional products) is 34% of Clorox’s total sales.

So, just for the sake of argument, let’s say that the Homecare business is going to increase by 10x for the next year. Yes, I don’t think it will be anywhere CLOSE to that, but let’s use some best-case numbers.

To make the calculations easy, let’s also assume that all segments of the company are equally profitable. That’s almost certainly not true (different segments will certainly have different profit margins), but I couldn’t find information on the profit margins of the Homecare segment vs. the rest of Clorox, and this assumption makes thing easier.

Here’s the consolidated financial statement for 2019.

To make this easy, let’s run all our calculations on a per-share basis.

As you can see above, in 2019 Clorox had a diluted net earnings per share of $6.32. If we assume that Homecare was 19% of total earnings, that means that Homecare was responsible for $1.20 of profits (and the rest of the company was responsible for the remaining $5.12/share).

If the Homecare segment’s earnings increase by 10x for 2020 then the Homecare segment would generate earning of $10.20 for 2020. Total company earnings would be $10.20 + $5.12 = $15.32/share.

So the Homecare segment’s hypothetical blockbuster performance in 2020 would increase the 2020 per share earnings from $6.32 to $15.32 (an increase of $9/share), and in 2021 it would revert back to the normal numbers.

How should Clorox be valued given these earnings?

Well, currently Clorox is being valued at a P/E of 26.49. The S&P 500 as a whole has a P/E of 18.41, which is still higher than the long-term average for the market.

Perhaps Clorox as a whole deserves a higher PE because it’s growing faster than the S&P? Nope. Over the last 10 years Clorox’s earnings per share (EPS) went from $3.79/share to $6.32/share, good for 6.18% per year. The S&P 500’s EPS rose 8.29%/year in that same time. Clorox’s earnings rose about 25% slower than the S&P – that certainly doesn’t justify a higher PE.

So what if the rest of Clorox was valued at the same multiple as the S&P 500 (18.41) and the Homecare segment was valued at at the current P/E (26.49)?

The rest of Clorox would be valued at ($5.12 * 18.41 = $94.25)

The Homecare division would be valued at ($1.20 * 26.49 = $31.79) for the earnings in perpetuity PLUS the additional profits of $9 for 2020, for a total of $40.79.

Assuming an absolute BEST CASE scenario regarding additional profits this year due to sales from Clorox wipes would result in a rational valuation of Clorox would be $94.25 + $40.79 = $135.04.

This is about 20% less than Clorox’s closing price on March 24, 2020.

It simply doesn’t make any sense, and my guess is that the irrational pricing of Clorox stock is the result of retail investors (i.e. you and me) hearing that Clorox wipes are sold out of the local grocery store and then buying Clorox stock without doing the math to see if it makes sense.

You could do a similar analysis on Costco and you’ll reach a similar conclusion.

My advice is to ignore stocks where investors are overreacting to positive news and aggressive buy stocks where investors are overreacting to negative news.

Too much debt

Examples:
Stock: AT&T (T) – $173B in debt, $349B in total liabilities
Stock: Comcast (CMCSA) – $109B in debt, $178.17B in total liabilities
Stock: Ford (F) – $156B in debt, $225B in total liabilities
Stock: GE (GE) – $94B in debt, $243B in total liabilities

Debt isn’t necessarily a bad thing. If debt is used to purchase an income producing asset or provide an education then it’s usually considered “good debt”.

But far too many companies have taken on far too much debt over the last 10 years. This debt has been used to enhance shareholder returns by buying back shares or paying larger dividends. These are terrible uses of debt.

Related: Avoid companies that borrow to pay a dividend.

And for whatever reasons, too many investors don’t seem to be fazed by the high debt loads. For example, pretty much every article analyzing AT&T has included a statement like this, “while the amount of debt is high, the interest payments are covered by the company’s cash flow”.

Of course the interest payments are currently covered by cash flow TODAY. No bank would have provided the loans if the company couldn’t handle the loans when they were issued. That’s never the problem.

The problem with debt is never when the economy is booming. The problem with debt manifests itself during a recession when profits drop.

For example, let’s take a look at GE (. They have about $91B in debt.

Their interest payments for 2019 were $4.324B.

Their earnings before interest and taxes (EBIT) was $8.760B.

That means 4.324B of the 8.76B was used to pay the interest on their loans. That’s just under 50%. And after including taxes and all other expenses, their total income was just $423M. Their debt payments are 10x as much as their profits! A slight downturn in their business and GE will no longer be able to afford their interest payments.

In fairness, we should note that GE has been reducing its debt over the last few years. Unfortunately, GE has not been paying down its debt using its profits. GE has been selling off pieces of its business to pay down debt.

This is not a formula for increasing the value of the company long-term. In fact, if we look at their GE’s sales over the last 5 years you can see there’s been a clear trend downward due, in part, to the sale of various parts of the business.

In the last 4 years GE’s sales have dropped from $116B to $95B. That’s a drop of 4.87%/year.

Debt reduces a company’s options, flexibility, and future profits.

And most worryingly, companies with a heavy debt burden are the ones that blow up and go bankrupt.

Companies that haven’t been through a full business cycle yet

Examples:
Stock: Uber (UBER)
Stock: Lyft (LYFT)
Company: WeWork (not publicly traded)
Sector: Crowd funded real estate (FundRise, RealtyShares, etc.)

I once heard second marriages described as the triumph of hope over experience. The same could be said about investors in the large number of businesses that were started after the Great Recession.

The true test of any company’s business model is not how much money it makes when the economy is roaring. The true test is how the company performs (or IF it performs) in a recession.

The ability to earn money through good times and bad is what makes a company a great long-term investment. Companies like Illinois Tool Works (ITW – 56 years of dividend growth), Colgate-Palmolive (CL, 57 years of dividend growth), and Johnson and Johnson (JNJ, 57 years of dividend growth) clearly have business models that work. They have managed to not just make money through good times and bad, but their business models are so solid that they can pay increasing dividends every year for decades.

In contrast, Uber and Lyft couldn’t even make money during a 10-year bull market!

Some companies (like WeWork) have a completely untested business model that could likely blow up in a recession.

And with the crowd-funded real estate market there are all sorts of questions. For example, how risky are the deals they present to investors?

The crowd funded real estate companies all claim that they have a strict evaluation process and they present only the best deals to their investors.

But the reality of these companies that just their model just doesn’t make sense. If you are a real estate investor with a track record of success and you’re looking for funding for a solid, well-vetted deal, why would you go to FundRise for funding when you could go directly to a bank?

I did a quick search on a few of the major crowd funded real estate website. Most of the deals being offered were equity deals. This means you’re becoming a partner in the deal. Every deal I saw was projecting a 15%+ IRR, with most of the deals having terms of 5-10 years.

This makes no sense.

If you are a real estate investor, and you have the option of either:
– Taking out a 10-year mezzanine commercial real estate loan at 5.7% – 7.7%
– Selling equity in the deal

The first option costs you 5.7% – 7.7% for the loan, but you enjoy all of the upside. The second option costs you the 15%+ expected IRR since you’re selling some of the ownership of the property.

There are only 3 reasons you’d sell equity:

#1 – You can’t get a commercial loan. If you can’t get a commercial loan then multiple loan officers at multiple banks looked at the investment you’re making and decided it wasn’t a good risk (after all, you only need to convince one bank to fund your project in order to get a loan). This means the deal is risker than presented.

#2 – You don’t want to take the risk of the loan. This likely means that the deal is riskier than presented.

#3 – You don’t think you’ll actually get a 15%+ IRR. If you think the actual expected return is closer to the cost of a loan then taking the no-risk equity investment would make sense. This means the deal won’t provide the returns that were presented.

So, by almost by definition, crowd funded real estate loans are lower quality and/or will provide a lower return than they are projecting.

As far as I can tell, so far these crowd funded real estate investments have performed fine. But remember, the risk isn’t that an investment will fail when the market is good. The risk is that an investment will blow up when the economy slows down.

Personally, with the exception of a few high-risk private investments I made a number of years ago, I stay away from all companies that haven’t proven their business model through a full business cycle.

Conclusion

While this list is by no means exhaustive, hopefully it gives you some ideas of the types of companies that you should probably cross off your list.

Again, this isn’t to say that all of these companies will end up being poor investments. However, I do believe they are higher risk than most people believe.

What other categories should I add to my “not interested” list?