Last week, we featured two guest essays from investing expert, Eric Fry, editor of Fry’s Investment Report and The Speculator. In the first, Eric discussed one of the biggest financial mistakes you can make … something that’s a retirement killer — in short, not having any sort of “wealth insurance” or plan to handle financial risk and a bear market.
In the second essay, Eric shared with us two of his six Bear Market Survival tactics. When done right, these tactics can help an investor not just survive a market in crisis, but thrive in it.
Today, we pick back up in our series from Eric with the topic of “brown bag stocks.” In short, that means if someone was to put a brown bag over the logos of these companies, and present you only their financial fundamentals, most investors would deem them to be a “sell,” if not a great short sale.
But if you removed the brown bag and revealed the names, those same exact investors would not be able to bring themselves to bet against such iconic and beloved brands.
But this decision could mean serious damage to your portfolio. Today, we dive these dangerous stocks, and reveal one which you might even own.
I hope you’ll make time to read this important essay.
The Danger in Owning ‘Brown Bag’ Stocks
In 1720, as the European powers squabbled over their American holdings, as Jonathan Swift started to write Gulliver’s Travels, and as the Chinese restricted all trade with the West to the port city of Guangzhou, Sir Isaac Newton did something stupid.
Newton, of course, was a brilliant guy. A key figure in the Scientific Revolution, he laid out the foundations of classical mechanics — the laws of motion and universal gravitation.
But just like all of us, Newton was susceptible to the folly of the crowd.
In the spring of 1720, he made a smart move and unloaded his South Seas Co. shares for a 100% profit. But then, just a few months later, he got swept up in the company’s astounding success, like much of Great Britain’s populace, and piled back in right near the peak.
This is how South Seas moved back then …
Newton ended up losing more than $4 million in today’s dollars. “I can calculate the movement of the stars, but not the madness of men,” he was quoted as saying.
As I said in my last report here, identifying great Forever Stocks to buy is a key part of Intelligent Asset Allocation.
But as Sir Isaac Newton’s story shows, growing wealth also relies on identifying bad stocks to avoid. A big loser can put a serious dent in a portfolio and derail the process of compounding gains.
For the paid-up members of my Fry’s Investment Report service, I recently identified three stocks that prudent investors should avoid. As I told my members, these companies might not collapse immediately, but at their current prices, they offer a lot more risk than reward.
All three of these stocks are facing competitive assaults on multiple fronts. Even worse, all three companies are struggling with financially stressed balance sheets. Two of these struggling companies have earned “junk” credit ratings from both Moody’s and Standard & Poor’s.
All three are also iconic brand names. As such, their shares may not seem like the type that would reward a negative bet like a short sale or put option.
However, brand-name companies can be some of the best stocks to bet against. They are so familiar to us that they seem safe — but familiarity does not equal safety.
On the contrary, familiarity obscures or desensitizes us to risks.
Names like Enron, Countrywide Financial, Fannie Mae, Xerox, AIG, Kodak, Blockbuster, and General Motors come to mind. Many times, companies like these maintain rich valuations for much longer than they deserve.
But a legacy of past success cannot gloss over lousy finances indefinitely.
When I was a hedge fund manager, I referred to stocks like these as “brown bag shorts.”
If you were to put a brown bag over the logos of these companies, and just presented their financial fundamentals, most investors would deem them to be a “sell,” if not a great short sale.
But then, if you removed the brown bag and revealed the names, those same exact investors would not be able to bring themselves to bet against such iconic and beloved brands.
Today I want to reveal a “Brown Bag Stock” to you. It’s heading down a long road of sluggish-to-negative organic growth and, therefore, a long road of disappointing results. At the same time, its debt levels are extremely elevated.
That combination is a classic recipe for disappointment. But judging by its stock price, its investors seem to be anticipating a rosy future.
I won’t identify this company at the beginning of my analysis.
Instead, I’ll explain my reasons for betting against this Brown Bag Stock — and then reveal its name at the end.
We’re Hatin’ It
The bear case for this Brown Bag Stock is elegantly simple: It isn’t growing.
In fact, it’s shrinking.
• The number of retail locations it operates in the United States has been dropping for four straight years, for a total decline of 3%.
• The average number of customers who patronize its U.S. stores has fallen five of the last six years, for a total decline of 13%.
• Companywide revenues have tumbled for five straight years, for a total decline of 26%.
Meanwhile, its debt load has nearly doubled during the last three years.
Still, despite these significant negatives, the company’s share price is flirting with all-time highs.
This striking divergence between a high share price and mediocre financial performance is baffling. But it becomes understandable after you realize that the company’s management has pulled a major lever to produce a picture of growth.
Specifically, it has borrowed a spectacular amount of money to conduct share buybacks. This activity not only helps to boost the share price, but it also inflates the company’s earnings per share (EPS).
By reducing the share count, management can show rising EPS, even if the actual earnings are flatlining. And since most investors focus on the EPS result, they might not even realize that actual earnings are doing a whole lot of nothing.
Here’s how share buybacks can pull earnings growth out of a hat.
EPS is simply a ratio calculation in which earnings are the numerator and the share count is the denominator.
Therefore, reducing the share count reduces the denominator of the EPS calculation. So if the earnings numerator stays the same, but the share count denominator shrinks, that calculation produces a higher number.
Let’s use this company’s actual earnings and share-count history to illustrate how this legal deception works.
At the end of 2013, this company’s share count totaled nearly 1 billion. Today, the total number of shares outstanding is only 763 million. In other words, the company has purchased and retired nearly 235 million shares during the last five years.
Hold that thought.
In 2013, this company produced pretax operating income of $8.76 billion. During the most recent 12-month period, the company produced operating income of $8.77 billion.
That’s virtually identical to the result from five years earlier.
That’s five years of no growth.
But thanks to the magic of stock buybacks, the pretax operating earnings per share jumped 31% over this time frame.
The math looks like this …
The 2018 tax cuts added an additional kicker to the company’s reported earnings, as its effective tax rate tumbled from more than 30% to less than 20%.
So when you take massive share repurchases, toss them into a jar with a massive tax cut, and shake vigorously, you convert zero growth into 35% growth.
But this financial alchemy doesn’t change the fact that the company is failing to grow.
Unfortunately, share buybacks of this size exact a heavy price on a balance sheet. The company has doubled its net debt to finance the buybacks. The resulting debt load isn’t life-threatening, just burdensome.
The company’s interest expense now chews up 17% of every (pre-interest) dollar the company earns. Five years ago, though, interest expense consumed less than 9% of every dollar earned.
A 17% bite might not seem so bad, as long as interest rates don’t rise. But every 1% increase in the company’s effective borrowing rate would take another 4% bite out of earnings.
Bottom line: This company produces cosmetically pleasing “growth” numbers but very little actual growth. Still, its stock is within a whisker of its all-time high and trading for a plump 26 times earnings. That’s 33% above its 30-year average valuation.
The company is McDonald’s Corp. (MCD).
I’ve always loved McDonald’s. I’ve loved it ever since I used to ride my Stingray to the local walk-up location after Little League practice and order a cheeseburger and a milkshake.
Maybe you love it, too.
But that doesn’t mean we have to love its stock as well.
My second Brown Bag Stock possesses a similar financial profile to McDonald’s: zero-to-negative organic growth, coupled with sky-high debt.
And my third Brown Bag Stock may be the most innovative company out there right now. The company deserves all the accolades it routinely receives for developing and manufacturing its sexy technology.
But unfortunately, sex appeal doesn’t pay the bills. So far — and it’s been a while — this company has not yet been able to convert its innovative vision into profitability. Perhaps it will one day, but that outcome is far from guaranteed.
Now, Newton wasn’t a dumb guy. And while they may not have invented calculus, neither are today’s investors in McDonald’s … or my two other Brown Bag stocks.
But we all can all let emotion get the best of us, join the crowd, and blind ourselves to sometimes. I know I have.
So the goal is to make smart decisions more often than we make bad decisions.
And right now the best decision you can make is easy.
Avoid wrecking your retirement by staying far away from all three of these Brown Bag Stocks. You can learn how to get the names of the other two by clicking here.
Next time, I want to unveil another of my Bear Market Survival Tactics. In fact, it’s my No. 1 strategy for insuring your wealth. Watch for that soon.
Fry’s Investment Report
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