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7 stocks to avoid

Glenn Freeman  |  21 Apr 2020Text size  Decrease  Increase  |  
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We regularly discuss companies Morningstar analysts believe are under-estimated by investors. But in the current environment, where the ASX 200 index has fallen by 23 per cent year-to-date, knowing which stocks to avoid is just as useful.

For the purposes of this article, I've used Morningstar Direct to find large-cap Australian companies regarded as both expensive and with a Morningstar Uncertainty rating of either high or very high.

A Morningstar Rating of 1- or 2-stars indicates a company is trading at more than what the analyst believes it is worth and indicates the risk of investing isn't outweighed by potential returns.

The Morningstar Fair Value Certainty rating represents the predictability of a company's future cash flows. It captures a range of likely potential intrinsic values for a company based on the characteristics of the listed company's underlying business. This includes such things as operating and financial leverage, sales sensitivity to the economy, product concentration, and other factors.

Fortescue Metals Group (ASX: FMG)

Economic Moat: None | Uncertainty Rating: Very High | Price-to-fair value: 1.66

The world's fourth-largest miner globally, Fortescue is regarded as a second-tier producer, which means its margins lag those of industry leaders BHP Group (ASX: BHP) and Rio Tinto (ASX: RIO).

This is the primary reason Morningstar’s commodity analyst Mat Hodge doesn't regard Fortescue as holding an economic moat—or sustainable competitive advantage.

"Competitive advantage in iron ore is all about low costs, and Fortescue is well behind industry leaders," he says.

Hodge notes the iron ore product the company produces is a lower grade, and so attracts a lower premium than many of its competitors.

Fair value uncertainty

Hodge's intrinsic assessment of what he believes the company is worth—with a fair value estimate of $6.80 as at 20 April—is also highly uncertain. This is attributed to a combination of high operating debt, single-commodity exposure in mining only iron ore and the cyclical nature of iron ore prices.

Hodge lauds management's rapid reduction of debt between 2016 and 2018 amid elevated commodity prices. But he believes iron ore prices are set to remain lower for longer, and tips Fortescue's margins to be even slimmer than those of its competitors.

In addition to being focused on a single commodity, Fortescue's heavy reliance on China's consumption presents another risk.

Afterpay (ASX: APT)

Economic Moat: None | Uncertainty Rating: Very High | Price-to-fair value: 1.41

Buy now pay later company Afterpay was added to Morningstar’s stock research list last September.

With high operating leverage, business risks and a raft of competitors, the company is currently trading at a 41 per cent premium to Morningstar's fair value estimate. Between the middle of February this year and 20 March, Afterpay's share price dropped from almost $40 to less than $10. 

"It's hard to imagine the historically strong growth persisting amidst the COVID-19 outbreak as it will likely lead to subdued consumer spending, widespread unemployment and potentially a global recession," says Morningstar senior equity analyst Mark Taylor. He cut his fair value estimate for the company to $20.50 a share from $23.50 on 1 April, on the back of anticipated slowing customer growth, flagging consumer spending and higher bad debt expenses.

Rising unemployment is also a key headwind. Up to one-in-four Australians could lose their jobs in the weeks ahead, leaving between 1.9 million and 3.4 million unemployed, according to the latest data from The Grattan Institute.

Taylor believes these conditions will hit discretionary spending, and has delayed by one year his forecast for Afterpay achieving profitability—now tipped to be revenue-positive from 2022.

But he maintains the coronavirus setback will likely only be temporary, and expects Afterpay will see a near-term benefit from more retailers shifting their businesses online. Some 75 per cent of the sales processed by Afterpay are e-commerce transactions.

"We also anticipate a rebound in spending activity starting fiscal 2022, driven by the likely availability of a coronavirus treatment which should help normalise consumer confidence, store footfall and subsequently economic conditions," Taylor says.

Rio Tinto (ASX: RIO)

Economic Moat: None | Uncertainty Rating: High | Price-to-fair value: 1.11

Another miner focused primarily on iron ore, Rio was also swept up in the share market sell-off between the middle of February and late March.

"But with the iron ore price trading well above the cost of production for the major miners, the iron ore miners remain the most expensive of our coverage," says Morningstar's Hodge.
Among iron ore miners, Rio’s share price is the most elevated, trading at a 39 per cent premium to Hodge's $66 fair value estimate as of Monday's close.

And Hodge rates this fair value estimate as highly uncertain, largely because of the miner's operating debt and exposure to volatile commodity prices.

No moat

Rio also lacks a moat, because Morningstar believes its iron ore cost advantage isn't likely to be sustained through a market downturn.

Hodge says business expansion during a period of high iron ore prices—coupled with the acquisition of a Canadian mining company and aluminium manufacturer he describes as "abysmal”—have knocked investor returns. "Particularly in a post-China-boom world."

Metcash (ASX: MTS)

Economic Moat: None | Uncertainty Rating: High| Price-to-fair value: 1.32

Metcash, the dominant supplier of packaged groceries to independent grocery retailers, on Monday announced a $330 million equity raising round. The move is pitched by management as a bid to build a "war-chest to buy other businesses", says Morningstar equity research director Johannes Faul.

"It's a good strategy, but I'd prefer them going to shareholders when they actually have a good acquisition in front of them."

Faul is also surprised at the announcement given the company's main business is food sales, followed by hardware supplies and liquor—all areas that have been performed strongly in recent weeks amid the global pandemic.

But Metcash management said the 4.3 per cent lift in food sales over the past five months was partially offset by higher costs to manage health and safety risks.

No scale advantage

Metcash’s small size relative to competitors—with a market cap of $2.4 billion versus $47.2 billion at Woolworths—is a key reason for its lack of an economic moat.

"The price war between the majors has magnified the discrepancy in value between these large banner groups and the smaller independent retailers," Faul says.

He also emphasises the company's high cost of doing business, as intense competition reduces margins—which has a bigger effect on smaller players. Metcash faces further risk from competitors Aldi and Costco, with their lower costs and more tolerance for lower margins than independent grocers and Metcash's IGA network.

The full list of Australian stocks that make this list:

stocks to avoid

is senior editor for Morningstar Australia

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