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May's Stock Red Flags

Three stocks we think investors should be wary of.

Morningstar Analysts, 05/23/2006

This article originally appeared in Morningstar StockInvestor.

In tables, click Star Rating, Business Risk, and Size of Moat to see definitions of these terms. Definitions are hosted on Morningstar.com.

We calculate the Risk-Adj. Ret by taking a stock's fair value and assume it will grow at the company's cost of equity over the next five years. This is the stock's fair value in five years. We then subtract out the "risk" of the stock--defined as its cost of equity plus a margin of safety. All data below are as of April 30, 2006.

We noted in November that Spectrum Brands SPC and First Marblehead FMD were two of our Red Flags that significantly fell after we first flagged them. Since November, Spectrum has continued to slide, and First Marblehead's stock has rebounded sharply.

Since we highlighted it a year ago, Spectrum has fallen by more than 50%, and after a bad early 2006, it now trades close to our recommended buy price of $15.90 per share. The firm's struggles can largely be attributed to its Rayovac battery business, which is experiencing shrinking margins and declining demand. These are two trends that Morningstar analyst Lauren DeSanto doesn't anticipate will subside. According to Lauren, "We expect the changing nature of electrical devices, coupled with consumer purchasing trends, will continue to pressure sales and profits in the category."

Although we think the bleeding will eventually stop, Spectrum's lack of an economic moat will keep us on the sidelines.

First Marblehead at one point was down almost 30% after its Red Flag selection in August, but after briefly trading around our $21 fair value estimate in October, the stock now stands at $44 per share.

Over the past six months, First Marblehead has extended its contract with Chase and renewed its contract with Bank of America, but the underlying business model has not changed. We continue to dislike the firm's reliance on the upfront fees it receives from student loan securitization and wish it would collect more fees from the processing of student loans, a much more stable cash-flow stream. Should this transpire, our opinion on the firm could become more positive, but until that happens, we are content with keeping our distance.

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