7 U.S. stocks to avoid

We suggest that investors avoid richly priced, high-uncertainty names, says Morningstar.com’s director of content, Susan Dziubinski

Susan Dziubinski 14 June, 2019 | 2:30AM

Caution

Death and taxes are two of the few certainties in life. In investing, too, there are few certainties. Of course, we can improve our chances of investing success by, say, favoring low-cost, broadly diversified funds. Or by buying stocks of companies with competitive advantages.

One thing would seem to be for certain, though: Investing in stocks with unpredictable cash flows when they’re trading at nosebleed valuations is a recipe for failure. These are stocks to avoid.

For today’s screen, we’re isolating stocks with high or very high uncertainty ratings that are trading at least 70% above our fair value estimates.

Before we share the results, let’s step back and review what the uncertainty rating is. The uncertainty rating represents the predictability of the company's future cash flows--and, therefore, the level of certainty we have in our fair value estimate of that company. We value a company based on a detailed projection of its future cash flows, and discount those flows back to today's dollars using a proprietary cash flow model. The uncertainty rating captures a range of likely potential intrinsic values for a company based on the characteristics of the business underlying the stock, including such things as operating and financial leverage, sales sensitivity to the economy, product concentration, and other factors. If the range of potential intrinsic values is narrow, the company earns a low uncertainty rating. If the range is great, the company earns a high uncertainty rating.

Is it so bad to buy an overpriced stock with high uncertainty, given that we’re not highly confident in our estimate of what that company's shares are really worth? Certainly, one might argue that in the case of a high-uncertainty stock, valuation could be tossed aside and one should instead focus on something else--growth prospects, for example. Given the lack of cash flow predictability, we could be underestimating the value of these names. However, we could be overestimating their value, too.

That’s why we err on the side of conservatism: We suggest that investors avoid richly priced, high-uncertainty names. If one is truly tempted to take on the uncertainty, we’d recommend doing so with only a significant margin of safety--even if that fair value is, in itself, uncertain.

Thirteen overpriced, high-uncertainty stocks passed our screen. Data is as of June 10.

Netflix (NFLX)
Fair Value: US$135.00
Price: US$356.79
Price/Fair Value: 2.61
Economic Moat: Narrow
Uncertainty: Very High

The priciest stock in our coverage universe--trading 161% above our fair value estimate as of this writing--Netflix continues to generate solid subscriber growth thanks to global expansion. However, the largest streaming video on-demand provider continues to burn cash, and management provided weak subscriber guidance for the second quarter, notes senior analyst Neil Macker. Granted, the company has carved out a narrow economic moat, but it also carries very high uncertainty. Competing streaming services from larger firms, such as Disney (DIS) and WarnerMedia, will constrain Netflix’s ability to raise prices without inducing greater churn, concludes Macker.

AMN Healthcare Services (AMN)
Fair Value: US$26.00
Price: US$52.46
Price/Fair Value: 2.01
Economic Moat: Narrow
Uncertainty: High

The largest healthcare staffing firm in the United States, AMN Healthcare stands to benefit from the increased use of healthcare services over the coming decades, given that the pipeline of healthcare professionals isn’t expected to keep pace with demand, says senior analyst Debbie Wang. It has carved out a narrow economic moat, thanks to the network effects tied to the quality and reliability of its workers and its relationship with providers, she adds. Yet Wang warns that this business is cyclical, and that cyclicality isn’t being reflected in today’s share price, which is assuming that recent robust performance will persist indefinitely.

Shopify (SHOP)
Fair Value: US$170.00
Price: US$305.54
Price/Fair Value: 1.80
Economic Moat: Narrow
Uncertainty: Very High

This cloud-based platform with multichannel offerings for small and midsize businesses posted strong earnings last quarter and significantly boosted guidance for the year. We, too, think the outlook for Shopify is bright: It has carved out a narrow moat, it continues to build out its ecosystem, and international adoption is high, explains sector director Brian Colello. Yet its payments revenue stream faces risks from competitors who are building out in-app capabilities, he argues.

Advanced Micro Devices (AMD)
Fair Value: US$19.00
Price: US$32.89
Price/Fair Value: 1.75
Economic Moat: None
Uncertainty: Very High

The semiconductor firm primarily competes with Intel (INTC) and Nvidia (NVDA), but has experienced market share loss in recent years, notes senior analyst Abhinav Davuluri. Specifically, Intel has leveraged its scale and massive R&D budget to widen its lead over AMD; Nvidia, meanwhile, has captured the lion’s share of the discrete GPU market. That said, we expect the no-moat firm to regain some market share, but we don’t think those gains will persist at the rate implied by the current share price, concludes Davuluri.

Dropbox (DBX)
Fair Value: US$13.00
Price: US$22.95
Price/Fair Value: 1.75
Economic Moat: None
Uncertainty: Very High

The first company to take file storage to the cloud, Dropbox hasn’t carved out an economic moat; despite its significant active user base, the company doesn’t boast a network effect, nor are there significant switching costs for users, argues analyst John Barrett. Moreover, the company hasn’t been able to drive paid user conversion of its base: More than 97% of Dropbox users view the service as a free cloud storage offering, nothing more. Though it has created collaboration tools to help drive upgrades, we don’t think users see significant differentiation in such tools, which is why paid user penetration is so low, concludes Barrett. And uncertainty around converting these free users to paying customers contributes to our very high uncertainty rating.

Wayfair (W)
Fair Value: $US88.00
Price: US$157.84
Price/Fair Value: 1.75
Economic Moat: None
Uncertainty: High

With a 100% online presence focused largely on home improvement and furnishings, Wayfair benefits from low overhead. However, the company hasn’t carved out an economic moat; its brand has limited pricing power, consumer switching costs are nonexistent, and it doesn’t maintain cost advantages, says senior analyst Jaime Katz. We think competitors will continue to focus on faster delivery, thereby spurring increasing competition. Adding more uncertainty, demand is tied in part to the health of the home improvement market and consumer confidence, concludes Katz.

VeriSign (VRSN)
Fair Value: US$120.00
Price: US$208.18
Price/Fair Value: 1.73
Economic Moat: Narrow
Uncertainty: High

Verisign’s leadership position as the sole registry for .com and .net and the operator of two root name servers (of 13 globally) contributes to the firm’s narrow moat. However, price increases have been limited, observes analyst Andrew Lange, and new generic top-level domains remain a modest threat. The firm also faces some competition from other registry services, such as Neustar and ARI. Lange is skeptical that the firm can achieve the growth and profitability that its rich valuation implies.

Securities Mentioned in Article

Security NamePriceChange (%)Morningstar Rating
AMN Healthcare Services Inc59.67 USD0.34
Dropbox Inc Class A19.21 USD1.96
Netflix Inc295.03 USD1.87
Shopify Inc A312.38 USD-0.02
VeriSign Inc186.81 USD-0.23
Wayfair Inc Class A83.71 USD0.67

About Author

Susan Dziubinski

Susan Dziubinski  Susan Dziubinski is director of content for Morningstar.com.