What's really hard is recognizing companies whose shares seem like they might be bargains, but that actually have subtle or hidden problems. These stocks truly belong your DO NOT BUY list.
A good example is Bank of America Corp. (NYSE: BAC). The financial sector was among the leaders as the market rallied from its July lows, but BAC didn't add much to the advance. In fact, after a brief bounce, it tumbled to a 12-month low of $12.18 on August 30 - a far cry from its October 2007 high of $52.71. Still, it looks like the stock built a solid technical base during the early September market upsurge and could be poised for a breakout if its earnings, due out Oct. 20, beat expectations.
Bank of America, specifically, will experience added drag from its ownership of Merrill Lynch, as well as a still-hefty list of "toxic asset" holdings, which have fostered an ultra-cautious attitude toward making new loans, thereby stalling revenue growth. That could mean another quarter of substandard or even negative earnings (the most recent trailing 12-month net was a 20-cent loss), and that will keep a lot of investors away by dimming hopes the company could begin restoring its dividend, which it has slashed from $2.56 in 2008 to just 4 cents.
In short, while BAC has some characteristics that make it look tempting, it also has plenty of remaining negatives - enough to keep it on your DON'T BUY list.
Five other stocks whose potential is currently overwhelmed by nullifying risk factors are:
1. Progress Energy Inc. (NYSE: PGN), recent price: $44.65: Electric utility PGN got a lot of attention on Monday because it experienced its own version of last May's "flash crash," falling from over $44 a share to just $4.57 in a matter of seconds on then recovering to close virtually unchanged. The action exposed a major flaw in the newly adopted circuit breakers designed to prevent such events, and most of the off-NYSE trades executed electronically were later cancelled. However, the fact PGN fell 10% in five minutes exposes some susceptibility to a future decline.
Prior to the unwanted attention, PGN had looked like a potential buy because of its steady rise from an early June low of $37.67. The stock also boasts a solid dividend of 62 cents per quarter (a 5.55% yield), which it has maintained since January 2008.
Progress has several innovative projects in the works, including a renewable energy program in the Carolinas where it is recovering gas from landfills. What's troubling, though, is that the company quietly reduced its profit estimates for the full 2010 fiscal year and said its quarterly earnings, due out Oct. 29, would likely come in at the low end of the projected $2.95-$3.05 range.
Couple that with the inability to get rate increases in several service areas, and PGN might have trouble covering its dividend (the current payout ratio is already an estimated 83%), leading to a reduction - an action that typically hammers a stock's price.
2. WMS Industries Inc. (NYSE: WMS), recent price: $38.30: Unlike many stocks that have yet to return to their pre-2008 levels, WMS - a leader in the design, manufacture and distribution of games and gaming machines for the global casino industry - climbed to a new five-year high of $51.77 in April. However, the gambling industry proved less resistant to the current downturns than recessions past, and WMS suffered, as a result. The stock fell below $36 before rebounding in the September advance.
That bounce, coupled with the company's announcement that its fourth-quarter profit would likely rise by 18% to a record 56 cents a share with full-year earnings reaching $1.88, gave the appearance of a recovery. A $200 million stock buyback authorization also made WMS seem like it might be a bargain.
However, the rise in quarterly profits was based largely on cost-containment efforts, not new sales - a process that may be difficult to continue in the coming year, as reflected in the company's projected 2011 growth of just 8% to 11%. The slow recovery in the casino sector also is slowing the company's cash inflow. Accounts receivable as a percentage of sales increased sharply over the past year, with day sales outstanding, or DSO (the amount of accounts receivable expressed as a multiple of daily revenue), rising by 78%.
Meanwhile, the gambling industry's ever-increasing demand for new game concepts has increased WMS' R&D spending, which could further cut into earnings.
3. Office Depot Inc. (NYSE: ODP), recent price: $4.54: U.S. President Barack Obama got lots of attention on Monday by signing into law a bill that allocated $30 billion in tax cuts and loans to small businesses. However, Office Depot's own Small Business Index, released Sept. 20, found that small business owners remain skeptical and are reluctant to spend in the face of higher healthcare costs and tight credit.
That will keep the pressure on Office Depot, which gets the bulk of its sales from small businesses. The stock may look like a bargain relative to its 52-week high of $9.19, reached back in April, but revenue is likely to remain flat, giving the company little chance to improve on the $1.76 loss it reported for the past 12 months.
4. Kellogg Company (NYSE: K), recent price: $50.81: Like the gaming industry, stocks in the consumer staples sector have traditionally been thought of as "recession-proof." That has benefited Kellogg stock, which has bounced nicely from its July low of $47.28. There's also room for it to return to its 52-week high of $56, which it hit in May while the rest of the market swooned. Kellogg just raised its dividend to $1.62 a share from $1.52 in 2009, providing a yield of 6.17%.
However, those positives mask the fact that Kellogg's net earnings fell 15% in the second quarter, forcing it to also lower its full-year 2010 estimates. The company also is struggling to overcome the recent recall of 28 million boxes of cereal, the bad publicity from which will likely keep a lid on the stock price well into 2011.
5. Nucor Corp. (NYSE: NUE), recent price: $38.35 - A slight rebound in the auto industry and construction markets in the past few months has brought a lot of attention to steel companies. Nucor seems like the bargain in the sector, trading just above the 52-week low it set in late August.
However, the North Carolina-based Nucor reported only a modest second-quarter profit and lowered its full-year projections. Trailing 12-month earnings now stand at just 47 cents. That makes it likely another adjustment will have to be made to NUE's $1.44 annual dividend (a yield of 3.83%), which has already been reduced from $2.00 in 2007. The new earnings estimates put the price/earnings (P/E) ratio at a whopping 79.8, far above both industry and market norms. That's not a very solid outlook for a company made of steel.
While there are more negatives to these companies than meet the eye at first glance, remember that these aren't short-sale recommendations. The stocks simply don't measure up when it comes to making selections that are likely to extend the gains the market has put together in September.
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