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April's Stock Red Flags

Three stocks we think investors should be wary of.

Morningstar Analysts, 04/25/2006

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 March 31, 2006.

In addition to death-care provider Stewart Enterprises, this month we're highlighting a pair of firms that are very similar to each other: Tyson Foods and Pilgrim's Pride.

Meat processing is a difficult industry that is characterized by its dismal returns on invested capital. And thanks to bloated inventories and fears over avian flu and mad cow disease, we are forecasting a rough year for the industry.
 
Here's what analyst Greggory Warren recently wrote in a stock analyst note:

"We continue to express extreme caution on the meat processors, given the stark increase in chicken supplies over the past six months and the likelihood that beef and pork supplies could head upward as well. Our greatest concern rests with the poultry processors, such as Tyson Foods and Pilgrim's Pride, which have seen export markets for chicken products decline dramatically as the avian flu virus has spread from Asia to the Middle East, Europe, and Africa."

This is the second time we've highlighted Pilgrim's Pride in Red Flags. Unfortunately, it was another warning that we were early on. After it was profiled in November 2004, the stock rose from about $27 to almost $40 in March 2005. However, over the past several months, the stock has been on a serious slide and is now trading around $20.

We believe Tyson and Pilgrim's Pride will eventually make it through the industry downturn and overcome fears of avian flu and mad cow disease. That said, there are plenty of firms that are less risky, more shareholder friendly, and generate stronger and more stable returns than either of these companies provide. The tough industry conditions these companies face are just one more reason to stay away.

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