Very few stocks are truly attractive now in terms of their valuation, says Haywood Kelly, editor-in-chief of Morningstar's retail products. And the counterpart to that is: There are names investors should avoid.
Kelly bases his avoid list on a stock's price, the company's future free cash flows, and its risk level, arriving at a "fair-value estimate" that's compared with the level the shares are trading at currently. Stocks that make the stay-away list at the moment include Amazon, eBay, and Yahoo! in technology, plus such diverse names as Delta Air Lines, FedEx, Krispy Kreme, and Medtronic.
However, Morningstar likes Texas Instruments and Applied Micro Circuits in the semiconductor sector and American Home Products and Elan in pharmaceuticals. Kelly points out that right now, only 20 large-cap names are on Morningstar's five-star list vs. more than 100 last fall. Moreover, when judged by his criteria, Kelly notes that most large-cap stocks emerge with a neutral rating at best.
Kelly made these comments in a chat presented on Thursday, Jan. 24, by BusinessWeek Online on America Online, as he replied to questions from the audience and from BW Online's Jack Dierdorff and Karyn McCormack. Edited excerpts from this chat follow. A full transcript is available from BusinessWeek Online on AOL at keyword: BW Talk.
Q: Haywood, thanks to some words from Greenspan, among other things, the broad market is edging back up again. Will that trend continue, and will we see 10,000 and more anytime soon?
A: Looking out long-term, I would be conservative when I estimate what stock returns will be. Given what valuations are today, a lot of top investors, including Warren Buffett and Jack Bogle, think that the most we can expect from the stock market is single-digit returns over the next 5 to 10 years. Your guess is as good as mine on the level of the Dow.
Q: What do you think about tech stocks now? Which tech areas should investors avoid?
A: We tend to think that some of the Internet stocks, such as Amazon (AMZN), eBay (EBAY), and Yahoo! (YHOO), are still way too expensive. One area [where] we do have some stocks we like is semiconductors. That's where we have high star ratings on stocks such as Texas Instruments (TXN) and Applied Micro Circuits (AMCC).
Q: I have 800 shares of Cisco (CSCO) that were given to me. What would you do?
A: Since I'm not a financial adviser, I can't comment on your particular situation. But I would say we think that CSCO is trading about where it should be, based on our estimate of fair value. There have been some concerns raised in the media about Cisco's accounting (see BW Cover Story, 1/21/02, "Cisco: Behind the Hype"), but we think that the financials of the company are still stellar. So I personally wouldn't hesitate to be long [on] Cisco.
Q: I'm considering purchasing shares of Intel (INTC). How do you feel about this stock?
A: We have it rated three-stars right now. Our fair value for the stock is right at $30. It closed today at $33. We love the company mainly because of its huge free cash flows, so it's certainly one that we would buy at the right price.
Q: Is Rite Aid (RAD) on the list to avoid -- and why?
A: We actually don't rate Rite Aid. That's mainly because it's in such financial distress that pinning any value on the stock is extremely difficult. We give the company a letter grade of F in profitability and in financial health. So this is a stock you wouldn't want to devote a large portion of a portfolio to.
Q: Tell us what your criteria are for branding a stock "avoid" -- and what some of the worst might be.
A: What we look at in rating stocks are the future free cash flows of the company and the risk level. That's judged by things like balance-sheet strength, competitive position, and long-term profitability. Some of the stocks that have our lowest rating right now would be: Delta Air Lines (DAL), FedEx (FDX), Hewlett-Packard (HWP), Krispy Kreme (KKD), Medtronic (MDT), UAL
, and Yahoo! Those are all one-star stocks currently.
Q: How do you determine free cash flow from investment research material we get off the Internet?
A: For any company, you can find its free cash flow in its 10K or 10Q report, which is available at www.sec.gov. We also display this figure, historically, on morningstar.com. It's just operating cash flow from the cash-flow statement, minus capital spending. When we calculate a fair value for a company, our analysts have to forecast these free cash flows out into the future. In general, when we analyze a company, we start with the cash-flow statement. A company such as Enron can report rising earnings, but the cash-flow statement shows you the real picture.
Q: I have 1,000 shares of Handspring (HAND). What do you think should be done with them?
A: Again, I can't give specific portfolio advice, but I would say we currently have Handspring as a one-star stock. This is a perfect example of a stock that has fallen a lot but isn't necessarily cheap. As we say in our Analyst Report, given the company's competitive pressures, inventory buildups, industrywide pricing war, and a poor near-term economic outlook, we think that there are just too many unknowns to make Handspring worth buying.
Q: I am very concerned about JDS Uniphase (JDSU). Your thoughts?
A: Even though JDS Uniphase, by its nature, is a very risky stock, we currently think that it's trading below its fair value. So it gets a four-star rating, currently -- four-star means that a stock is undervalued. Granted, given how unpredictable the company's sales are, any fair-value estimate is a very rough guess.
Q: Does AOL have more downside, or would you start buying at these levels?
A: We think that AOL is a pretty good value at $28. That's where it closed today. Even though the company has a lot of debt, it generates substantial free cash flow. And those free cash flows drive our fair-value estimate of $40 a share.
Q: It seems like J.P. Morgan (JPM) has nothing but bad news lately. Would you avoid them?
A: Although J.P. Morgan Chase earns a four-star rating right now and a low-risk rating, our analyst is fairly pessimistic about the company's future financial performance. We have some concerns that long-term revenue growth will be lackluster. That's because we think that the firm is having a hard time blending J.P. Morgan's investment bank and Chase's lending arm into a single business. So overall, we're fairly lukewarm on the company's prospects.
Q: Would you be a holder, buyer, or seller of Tyco (TYC)?
A: Very good question. We just published a new report on Tyco this week. And our new fair value for the stock is $55. That's compared with the closing price today of $44. But we took our fair value down from $65 a share. Although we're much less bullish on the stock, we think it's significantly undervalued.
Q: I'm wondering if Morningstar had any worries about Enron.
A: An excellent question. Unfortunately, we were late in telling people to run like crazy. Our analyst suggested that investors sell when the stock was at $10. But we were wrong on the stock before then. Enron is a perfect example of a company whose story sounded very compelling -- but whose cash flows never matched the hype. What we took away from Enron is to steer clear of any company that's more interested in where its stock price is and what analysts think of the company than in helping investors to understand its business.
Q: In the wake of Kmart's (KM) bankruptcy, do you see any other retailers in jeopardy we should steer clear of?
A: Several of the big department stores earn low ratings from Morningstar. Those include J.C. Penney (JCP), Sears Roebuck (S), and Target (TGT). Even though Target is a great company, we think that the stock is currently too expensive. All three of these companies are two-star stocks -- meaning that they're at least 10% overvalued.
Q: What do you think of Oracle (ORCL) at its recent price?
A: Right now, with the stock at $17, it's trading right around our fair-value estimate. So we think that the stock is pretty much fairly valued at these levels.
Q: Given the risk-reward equation, wouldn't Global Crossing (GX) be a good speculation to survive?
A: As of our last Analyst Report, we came out and said that investors should avoid Global Crossing. I really can't say what the company's chances of survival are [Editor's Note: Global Crossing filed for Chapter 11 bankruptcy protection on Jan. 28].
Q: How do you feel about the railroads -- in particular, Union Pacific (UNP)?
A: Union Pacific currently has a two-star rating. Even though the company's growth and profitability are mediocre at best, it does have a solid balance sheet. And at the right price, it's a stock that we'd recommend. It's just not at the right price right now!
Q: What about Ciena (CIEN)? Will it recover soon?
A: Currently, we have a fair value on the stock at $20, compared with a $14 price. So right now, it earns a five-star rating. How long it will take to rebound, I really can't say.
Q: We've had questions on pharmaceutical stocks Bristol-Myers Squibb (BMY) and Pfizer (PFE). Where do they stand?
A: Currently, two pharamaceutical stocks earn five stars: American Home Products (AHP) and Elan (ELN). Some of the Big Pharma stocks, like Merck (MTK), Bristol-Myers Squibb, and Pfizer are all trading right around our fair-value estimate. Therefore, they earn three stars.
Q: And in telecom, the audience has asked about AT&T (T) and WorldCom (WCOM).
A: AT&T trades close to our fair-value estimate of $19. WorldCom trades well below our fair-value estimate of $17. So of the two stocks, we think that WorldCom is more attractively valued.
Q: So, sum up for us what stocks we should be sure to avoid, Haywood.
A: We would be very wary of the big-name Internet stocks such as eBay, Yahoo!, and Amazon. And we would caution that most large-cap companies appear fairly valued, or worse. Right now, only about 20 stocks out of the 500 we rate earn five stars. Last fall, that number was well over 100. At morningstar.com, you can find our star ratings and stock grades.