3 Stocks to Avoid

Our screen has identified overvalued UK and US stocks with no economic moats and high uncertainty ratings

James Gard 2 June, 2021 | 9:05AM
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Our recent article “Stocks that Let You Sleep at Night” profiled six low-stress companies that are strong, reliable and dependable. Now we highlight stocks that are likely to keep you awake in the small hours.

The recent shake-up in the stock market, which has boosted value stocks at the expense of 2020’s high-flying growth names, has changed the dynamic of the UK stock market. Companies that were trading below their fair value last year have moved to a level where they are fairly valued, or in some cases are looking expensive. 

The Morningstar star rating, which runs from one to five, can be a useful tool in identifying companies that have been left behind – or ones to avoid as their price has moved too far ahead. A 5-star rating indicates a business trading for less than it is worth, while a 1-star rated stock is deemed to be expensive relative to its fair value.

Our screen factors in star ratings, economic moats, as well as the fair value uncertainty ratings. This last factor is a risk rating, which assesses how volatile earnings or cash flow are likely to be in the next five to 10 years. The official methodology explains it as: “Morningstar’s Uncertainty Rating captures the range of potential intrinsic values for a company and uses it to assign the margin of safety required before investing.”

3 UK Stocks to Avoid

High uncertainty UK stocks

We looked for stocks rated one star, with no economic moat, and a high uncertainty rating - no UK stocks fit the bill. The above table shows those stocks which have two out of three of these characteristics.  

Ashtead

Ashtead (AHT) is a 1-star stock with no economic moat and possessing a medium fair value uncertainty. The commodity boom this year, with surging prices for copper and iron ore prices, has boosted the share prices of listed mining companies. Its shares are up 47% this year, following a 44% gain in 2020, which explains why it is now looking expensive compared to its fair value. 

The company, which rents industrial equipment like forklift trucks, has seen its shares hit record highs this year. Morningstar analyst Matthew Donen praises the company’s ability to generate cashflow and resilience during the pandemic. But he says that the shares are now “richly valued”, and the company has no economic moat because the equipment rental sector is highly fragmented and has price-sensitive customers who can switch easily to other companies. This commodity surge has also put miner Rio Tinto (RIO) into the rare position of being the only Morningstar rated stock with a 2-star rating, no economic moat and high uncertainty rating.

Anglo American 

A fellow London-listed miner, Anglo American (AAL), is the only company with a 2-star rating, no economic moat and very high uncertainty rating. Its shares are up almost 32%, now trading around £31 a share - significantly above the fair value estimate of £22.

Morningstar analyst Mathew Hodge expects commodity prices to cool off as China focuses more on consumer goods and services than industrial output, which has recently been driving demand for the likes of iron ore and copper. Keeping costs low is key to miners’ profitability (and obtaining an economic moat), Hodge adds, noting that Anglo isn’t one of the low cost operators in the industry. He rates the company’s balance sheet strength but says that Anglo has profit margins below its peers and is exposed to volatile commodity prices – as well as industrial unrest in it is home country, South Africa. 

11 US Stocks to Avoid

US overvalued stocks

The same screen applied to the US market had far more success, with 11 companies meeting all three criteria: 1 star, no moat, high uncertainty.

Dr Reddy

Shares in US-listed Indian generic pharmaceuticals firm Dr Reddy’s Laboratories (RDY) rose 70% in 2020. The generic drug industry is a classic no-moat sector, says analyst Damien Conover, with no barriers to entry and commodity-like products. “We assign Dr. Reddy a very high uncertainty rating due to its focus on commodity products in a highly competitive market with peers with significant scale,” he says. Regulation in developed markets is also a risk factor, he says. “The majority of the company’s revenue is in North America, where competition and price erosion have been the most significant.”

The company is one of two in our list of US stocks to avoid that combines extreme valuation with no moat and very high uncertainty - the other being gold miner Agnico Eagle Mines (AEM). Other names in the list include sports apparel company Under Armour (UA), e-commerce company Wayfair (W), and Dick’s Sporting Goods (DKS) whose shares have climbed 43% as it benefits from the re-opening of the US economy. 

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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About Author

James Gard  is content editor for Morningstar.co.uk