February's Stock Red Flags

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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 Jan. 31, 2006.

We featured General Motors GM as a Red Flag way back in August 2003. At the time, GM's stock price stood at $37.43, and the firm faced most of the same problems it does today: declining market share, high operating expenses and unwieldy benefit plans for both current and past employees. Since then, GM's shares have fallen by more than 40%.

This month, GM makes the list again, but this time we've added Ford F. Our auto analyst John Novak recently bumped GM and Ford's risk ratings from "above average" to "speculative" and lowered his fair value estimates for both companies citing rapidly falling market shares and large pension liabilities. This makes both firms prime Red Flag candidates.

In the long run, GM's and Ford's success is largely contingent upon them striking a deal with the UAW. While one would think it would be in the best interest of its members for the UAW to cooperate, large unions have not always agreed to employers' demands. One needs to look no further than the legacy airlines like United Airlines and steel companies like LTV to see what happens when unions play hardball. Novak said, "The specter of Chapter 11 bankruptcy at either company remains a small, but real, risk that likely will increase with time."

We think investors would be wise to avoid these two stocks. Not only do they carry a significant amount of risk, they also lack any form of economic moat. Instead of representing ownership in vibrant operating businesses, these stocks today are little more than highly leveraged bets placed on the negotiating resolve of the union, future health-care costs, and the returns the stock market as a whole give to each firm's pension accounts. PAGEBREAK