5 Stocks to Avoid

At Morningstar, we spend a lot of time talking about wide-moat, low-uncertainty stocks. When selling at a reasonable price, these stocks are what we call "fat pitches": companies with predictable earnings and long-term staying power trading at significant margins of safety. Invest in these stocks when they're undervalued and, over the long term, you're almost sure to accumulate wealth.

At the opposite end of the spectrum lie stocks that investors shouldn't touch: no-moat, high-uncertainty companies trading well above their worth. As we've noted before, there can be plenty of reasons to invest in a low-quality, high-uncertainty stock--but these stocks require deep discounts to fair value to compensate for their risks.

Even after a sluggish 2015 market and a volatile start to 2016, there are several lower-quality companies still trading well above their fair values. As of this writing, all of the no-moat stocks listed here are trading in 1- or 2-star range and earn fair value uncertainty ratings of high or greater. They're also large, carrying market capitalizations of at least $10 billion.

Nvidia enjoyed strong successes from its gaming, data-center, and automotive businesses in 2015. With those successes, however, came an inflated stock price. And despite those recent successes, Nvidia has yet to carve itself a moat.

Says analyst Abhinay Davuluri:

"We believe Nvidia does not have a moat. The graphics market is highly competitive, with

"Ultimately, the risky nature of Nvidia's nongaming and GPU segments leads to our high uncertainty rating. In the automotive space, other chipmakers compete for automakers' business and, thus, Nvidia's expected competitive position may not come to fruition. Although GPU acceleration has garnered attention from major data-center users, there are other methods for improving server performance. For example, the incorporation of programmable logic devices with server processors has the potential to become the preferred method of acceleration."

Nippon Telegraph & Telephone has a split personality: On one hand, two thirds of its consolidated value comes from its ownership stake in world-class wireless business

In his report, Morningstar senior equity analyst Dan Baker notes:

"We assign no economic moat to NTT. The business has generated a return below its weighted average cost of capital for each of the past seven years, and we expect this to continue for the next five years. About two thirds of NTT's earnings are generated by its 67% stake in NTT DoCoMo, which we rate as a narrow moat, and which generates returns of about its weighted average cost of capital or slightly above. However, we estimate returns on the fixed-line business averaged around 1.5% per year during the past seven years, dragging consolidated NTT returns below the weighted average cost of capital.

"Conceptually, most fixed-line telecommunications businesses have narrow moats because the capital costs associated with network rollout to the customer premises 'the last mile' make them natural monopolies, particularly in less densely populated areas. However, a number of key factors have made this less so for NTT. First, the regulator allowed competitors to access NTT's last-mile local loop network at very low prices, removing from NTT a lot of the economic rent able to be captured by fixed-line incumbents in other markets. This, along with favorable government tax and interest treatments for fibre rollouts, encouraged NTT and competitors to aggressively roll out fibre. Japan has a high population density with significant apartment living, which makes it more economical for more than one operator to roll out fixed-line services."

The market sees a lot to like in insurer Markel. While most insurers return the majority their free cash flow, Markel retains most of its capital, with a goal of compounding it at high rates of return over a long period and creating value for shareholders. Tom Gayner, who heads up investments and is involved in the company's acquisitions, has generated an impressive record as an equity investor by focusing on sustainable business with capable managers trading at fair valuations.

Though the story sounds familiar (Berkshire, anyone?), we view Markel as an overpriced, no-moat stock. Notes senior equity analyst Brett Horn:

"Markel has built a reputation as a 'mini-Berkshire,' and while we think it has developed a solid franchise, we believe the premium the market awards the company based on this narrative is not fully justified. We prefer insurers that focus on producing superior underwriting results. Markel's performance on this front is decent, but not good enough for us to award the company a moat.

"At first glance, Markel would appear to have the making of a moaty business, as it focuses on specialty lines. The company has substantial excess and surplus lines operations. But it also focuses on niche underwriting areas such as insuring summer camps, child-care centers, and livestock. We think the most common path to a moat for property and casualty insurers is to focus on niche lines such as these. However, underwriting results have fallen a bit short of the strongest players in the industry, largely because of a relatively high expense ratio."

PLD

This industrial REIT boasts a global scale, which makes it a preferred partner for firms seeking distribution facilities and investors looking for exposure to the industrial sector. But that global scale makes Prologis vulnerable during a global slowdown.

Notes sector director Stephen Ellis:

"Prologis' business is leveraged to the health and growth of the global economy, global trade, and online commerce, so anything that hinders these could compromise its business. Economic downturns can hurt Prologis' business more than other areas of commercial real estate because of their negative impact on economic activity.

"We think Prologis lacks a moat. To earn a moat rating, companies must earn returns on investments that exceed their estimated cost of capital. Our preferred return metric for REITs is return on real estate assets, or ROREA, which we estimate as EBITDA less maintenance capital expenditures, divided by the gross book value of revenue-generating real estate assets. We estimate that ROREA has averaged less than 5% recently, and we expect it to remain below 7% across our 10-year forecast. Both historical and expected future levels of ROREA fall below our estimate of Prologis' cost of capital, and we think this supports our no-moat rating."

Among the world's largest and lowest-cost copper producers, Southern Copper seems well positioned. But its shares look significantly overvalued given our $2 per pound forecast for copper.

Notes sector director Daniel Rohr:

"We expect China's copper needs to fall in 2016 and 2017 as real estate activity fades to a level more commensurate with underlying urbanization trends and power spending shifts away from copper-heavy distribution to copper-light transmission. On the supply side, cost deflation, a flattening of the cost curve, and rising scrap supplies all threaten prices. Our analysis points to sub-$2 copper in 2016 and 2017 and only a modest recovery thereafter.

"We see significant downside risk in copper-mining stocks. All else equal, we'd prefer low-cost miners that can generate free cash flow amid persistently low prices. Yet, quality doesn't come cheap. Southern Copper, one of the lowest-cost producers we cover, looks highly overvalued."