4 Red-Flag Stocks to Sell This Fall

BALTIMORE (Stockpickr) -- A rising tide lifts all ships -- except the ones with holes in the hull. They still sink regardless.

That's why it's so important to stay vigilant in a bull market. Plenty of damaged stocks can appear to get lifted by a buoyant market, only to put your portfolio underwater when Wall Street catches onto the holes.

Sure, a weakening stock can get floated higher temporarily by indiscriminate buyers in a bull market, but that doesn't carry over when the bears come out. When the broad market's in a downtrend, deteriorating firms are all but guaranteed to get sold off hard. The challenge, then, is to know what to look for before your shares get shellacked.

So today, we'll attempt to spot the red flags in four big names.

We're looking at a combination of highfalutin metrics that point to money problems for companies. To make our list, a stock has to has to meet three out of these four red flag criteria: a bankruptcy prediction formula called Altman's Z-Score that registers at less than 1.8, indicating financial distress; rising CDS spreads, indicating that institutional investors are pricing in a higher probability of bond default; and dropping sales and inventory turnover.

That quantitative approach to finding out red flags avoids the bullish bias that's historically put blinders on investors. So, without further ado, here's a look at four red-flag names to sell this fall.

Navistar

There's no question about it: 2013 has been a stellar year for shares of Navistar (NAV). Since the first trading day of January, shares of the heavy vehicle maker have jumped 57%. But with red flags flapping in this stock's financials, anxious shareholders may want to think about taking some gains off the table.

Navistar is a leader in the heavy vehicle business. Its brands include flagship International, as well as Monaco Coach and MaxxForce engines, giving NAV market-leading positions in three quarters of its business lines. But it's a company that's well-positioned in an extremely challenging industry. Economic headwinds continue to be a problem for NAV, especially as defense budgets get cut and high oil prices spur more shippers to go with rail transport. While the commercial vehicle fleet is aging, uncertainty could convince owners and operators to prolong use of older trucks.

Navistar has a long track record of destroying shareholder value, and failing to meet deadlines. While a recent management shakeup in 2013 could help NAV turn a new leaf, other headwinds, like a pension plan that's underfunded to the tune of $1.4 billion, could leave the new managers with few options. Debt has nearly doubled in the last two years -- and lenders are hiking NAV's cost of capital in turn.

At the very least, buyers should wait for more of a management track record before thinking about building a position in this name.

J.C. Penney

Don't let J.C. Penney's (JCP) household name status fool you: This stock has some serious problems on its hands.

J.C. Penney is a national department store chain that's been in flux for the last several years. The firm has a massive footprint -- more than 1,100 stores at last count -- and it's an anchor store at almost every mall in America. But big scale isn't a good thing when you're hemorrhaging money, and the firm's huge losses quarter after quarter should be worrying investors. While Penney's focus on providing consumers with a value proposition was a step in the right direction, the message has been muddled somewhere between the investor calls management makes and consumers' ears.

In many ways, the economic recovery is actually hurting Penney, not helping it. Upper middle class consumers are trading up to higher-end retailers at the same exact time that Penney's more price-sensitive buyers are getting squeezed out of the picture. Without a real reason to shop there, consumers won't. Since former Apple (AAPL) retail head Ron Johnson was fired from JCP's CEO role before completing the firm's brand revamp, his tenure only destroyed shareholder value. And returning CEO Mike Ullman is going to have to burn through even more cash to make Penney's image cohesive again.

The financial situation at JCP is strained. Rumors of a credit squeeze from vendors sparked a selloff in JCP stock back in August, and the store chain literally can't afford another quarter like its most recent one without borrowing money. At that rate, it'll run out of cash by the fourth quarter.

Expect more volatility from JCP in 2013.

Frontier Communications

Frontier Communications (FTR) is a dividend trap. Right now, the $4.3 billion communications firm pays out a whopping 9.2% yield. Yes, telecoms are known for hefty dividend payouts, but FTR's yield is ridiculous. Last quarter, for example, Frontier paid out more cash in dividends than it earned in all of the last year. That's not sustainable.

Frontier is the phone and internet provider for 2.9 million customers in 27 states. The firm transformed its business dramatically in 2010, when it acquired Verizon's (VZ) fixed line business in 14 states, a move that took the worst of Verizon's dragging fixed operations off of its books and moved them onto Frontier's. As a result, customer attrition is a big risk that's showing itself on FTR's top line. A huge debt load doesn't help things either -- if Frontier can float its dividend payout on for much longer, it'll be impressive.

FTR is no stranger to dividend cuts, and investors should hit the escape hatch before the next one hits. Frontier, after all, is a company whose price is largely predicated on its dividend. A cut will mean a disproportionate drop in share price.

JetBlue

Richard Branson once joked that the best way to become a millionaire was to be a billionaire and buy an airline. JetBlue (JBLU) shareholders should heed the warning. For full disclosure, JetBlue was a name I had recommended to clients in 2011 -- but we took the position off the table in the first quarter of this year as it staged a financial about-face. And it's been headed lower ever since.

To be clear, JetBlue isn't the worst company in the world. But the headwinds in the airline industry coupled with small-cap scale are making it more challenging than ever to compete with the big boys. And the big boys are only getting bigger -- industry consolidations are creating larger airlines than ever before that are better able to cut costs across massive networks. While increased routes have boosted JBLU's revenues, profitability has been tenuous thanks to growing maintenance and repair costs. Despite incurring the costs one of the youngest fleets in the airline business, it costs more than ever to keep those planes flying.

And JBLU needs to keep those planes flying if it wants to pay for those leases. The one-two punch of huge ongoing lease obligations and low margins makes this a tough stock to love. There was a time when I liked JetBlue a lot (and I certainly wouldn't recommend shorting it with the headline risk of an acquisition) but the red flags are waving too blatantly to ignore in 2013.

To see these stocks in action, check out the at Red Flag Stocks 2013 portfolio on Stockpickr.



-- Written by Jonas Elmerraji in Baltimore.

The 20 Most Important Things Proposed by Howard Marks (Part III Of IV)

11. The Most Important Thing Is… Contrarianism

"To buy when others are despondently selling and to sell when others are euphorically buying takes the greatest courage, but provides the greatest profit." – Sir John Templeton

Howard describes most investors very simply: trend followers. The above average investors must be insightful, skillful, second level thinkers and diverge from the consensus portfolio. Sometimes following the crowd or herd can be profitable, but at other times it my prove to be very unwise and the most unprofitable. At certain inflection points as value investors we must diverge from the crowd, due to fear and skepticism or hope and greed (be greedy when others are fearful and fearful when others are greedy).

Take the lemming as an example. If only this creature had the foresight to stop and leave the warmth of the herd before running over the cliff to its demise for the sake of following. A simple contrarian policy is to buy when they hate them and to sell when they love them, but it may be simpler to say than to do. You have to have the ability to ignore conventional wisdom (as Buffett says, long on conventional short on wisdom) and stick your neck out telling the market it is wrong, as it occasionally is. Contrarians may be strong believers in reversion to the mean and have a strong sense of "intrinsic value" and "a margin of safety" to last through the emotional roller coaster of cycles and swinging of the market pendulum discussed in part II.

Although, as a value investor there is a large difference between "it is over priced" and "it is going down tomorrow." Or, as the famous Keynes quote says, the market may remain irrational longer than one can remain solvent. But if you believe what everyone else believes, you will do what everyone else is doing, and end up with the same results. Howard says in short, two key primary elements to investing are: "A) seeing some quality that others don't see or appreciate (and that isn't refle! cted in price) and B) having it turn out to be true (or at least accepted by the market)."

By definition to be a contrarian is to "oppose or reject popular opinion; going against current practice." As Yogi Berra had said famously, "Nobody goes to that restaurant anymore; it's too crowded." Over course logically it does not make sense, just like the statement "everyone knows that investment is a bargain"; if they did then it would no longer be a bargain as the price would be bid up.

Sometimes when bargains arise, investors are unsure of what to do or how to interpret certain information and will tell themselves that they will wait until the dust settles. I have heard numerous times the dangers of "catching a falling knife" from friends and colleagues — a t which point, shortly after, the knife has been picked up and taken away by other investors, or as the dust settles there is no longer a bargain to be had.

It is important to weigh what might happen in any given situation against the probability of it happening and act accordingly. The unfortunate truth about being a contrarian at times is that it can be quite lonely, or as Howard Marks said in "Everyone Knows, " "It should be clear from the first element that the process has to begin with investors who are unusually perceptive. Unconventional, iconoclastic or early. That's why successful investors are said to spend a lot of their time being lonely."

12. The Most Important Thing Is… Finding Bargains

Bargains may be found when perception is exceptionally worse than reality. A process where every investor should start is having a list of potential investments, estimates of their intrinsic value, a sense of how large or small the margin of safety is in regard to price and an understanding of the risks involved with each or the correlation among the various asset classes. When you research an investment, if it is fairly valued or richly valued, ask yourself at what price you would buy. As ! Peter Lyn! ch famously said, "My philosophy has always been, the one who turns over the most rocks, wins the game."

It is important not to reach for yield or to buy at euphoric parts of the cycle, waiting patiently for bargains to come to you. I think of it much like a garage sale or auction where there are many willing buyers participating, but most participants know very little about the value of the items they are buying and are simply buying because they "want" them. Buying regardless of price is no way to prosper financially in the investment world or in everyday life. We must distinguish the difference between price and value clearly, as bargains usually involve irrational behavior or participants not knowing something about them. Being prepared and working hard are the keys to finding bargains.

Howard says these following places are a great place to start to look or turn over rocks. "A) Unknown areas or not fully understood, B) fundamentally questionable on the surface, C) controversial, unseemly or scary and finally D) deemed inappropriate for respectable portfolios."

13. The Most Important Thing Is… Patient Opportunism

"The market is not a very accommodating machine; it won't provide high returns just because you need them." – Peter Bernstein

As talked about briefly throughout part I, part II and above, the best strategy is often sitting on your hands waiting patiently for bargains to present themselves. Think of the pendulum if you wish as a boomerang that is more accurately caught waiting for it to return to you rather than chasing it down and trying to catch it. Oaktree says one of their mottoes is exactly that, "We don't look for investments; they find us." Marks' tells an intelligent story about the early rise of Japanese culture in business (brought about by William Deming). He talked about the word mujo embedded in the Japanese culture. It means cycles will rise and fall, things will come and go, and our environment will change ! in ways b! eyond our control. We must be prepared and we must be patient.

Insightfully provided are two keys during a crisis. A) You must be insulated from forces that require selling and B) be positioned to be a buyer instead. To be able to do so, an investor must have "a staunch reliance on value, little or no use of leverage, long-term capital and a strong stomach."

14. The Most Important Thing Is… Knowing What You Don't Know

"It's frightening to think that you might not know something, but more frightening to think that, by and large, the world is run by people who have faith that they know exactly what is going on." – Amos Tversky

There are things in the world that you know you know, there are things you know you don't know, there are things you don't know you know, and there are things you don't know you don't know. Understanding what you don't know and focusing on the things you may be able to control or "knowing the knowable" can provide valuable insight, save time and suppress anxiety. Taking an agnostic view combined with skeptical optimism is a healthy way to live in my opinion, as I do. It can lead to confrontations and arguments, or as I call them, "informative debates."

The most important aspect is second thinking everything, taking an abstract view of how it is conveyed and the incentives behind the proposals, or even more importantly knowing what you cannot know. Big problems may arise when investors forget that there is a difference between probability and actual outcomes and can be caught up in the dogma of others. Staying within your circle of competence, as Warren Buffett says, will lead to better investment results and more importantly, steer you clear of investment mistakes. Are you part of the "I know" school or the "I don't know" school?

Howard Marks provides a way to identify the "I know school" below.

1) They think knowledge of the future direction of economies, interest rates, markets ! and widel! y followed mainstream stocks are essential for investment success.
2) They're confident it can be achieved.
3) They know they can do it.
4) They're aware lots of other people are trying to do it too, but they figure either a) everyone can be successful at the same time or b) only a few can, but they're among them.
5) They're comfortable investing based on their opinions regarding the future.
6) They're glad to share their views with others, even though correct forecasts should be of such great value that no one would give them away gratis.
7) They rarely look back to rigorously asses their records as forecasters.

If you are a part of the "I don't know," you will be tired of saying, "I don't know" to friends, colleagues and family. As Mark Twain said, "It ain't what you don't know that gets you into trouble. It is what you know that just ain't so."

15. The Most Important Thing Is… Having a Sense of Where We Stand

"We may never know where we're going, but we'd better have a good idea of where we stand."

Markets cycles have a profound influence on the performance of investors and are both inevitable and unpredictable. As investors the questions we most often ask, and the answers we most often receive, are obvious, and more often then not, they are not the correct ones. We must be both proactive in controlling risk, (thus minimizing mistakes) and reactive in approaching opportunities, bargains and investor sentiment or attitudes towards the present situation. Knowing where we stand much relates to part II, being aware of the pendulum as well as being attentive to cycles.

Howard Marks talks about "taking the market's temperature" through various questions like, "Are investors optimistic or pessimistic? Do the media talking heads say the markets should be piled into or avoided? Are novel investment schemes readily accepted or dismissed out of hand? Are securities offerings and fund openings being treated as oppo! rtunities! to get rich or possible pitfalls? Has the credit cycle rendered capital readily available or impossible to obtain? Are P/E ratios high or low in context of history, and are yield spreads tight or generous? Is too much money chasing too few deals? Has the number of deals increased and the ease of them being done less prudent?"

Understanding where we are should be attentively pursued to a certain extent, the same extent in which you would look at the weather outside when deciding what to wear on any given day. Of course the weather outside is more of an objective matter, where as understanding of where we are in a market cycle may be more objective. This business is the art in which investors must practice and gain from experience, like many other areas of the investment process.

Further reading:

"It is what it is"