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Stock Strategist

Waving the Red Flag on Three Companies

We recently highlighted this trio as Red Flags in Morningstar StockInvestor.

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Morningstar StockInvestor, the publication that I edit, may be best known for its Tortoise and Hare model portfolios. These are portfolios that focus on owning companies with wide economic moats, and the "Fat Pitch" strategy that I employ has allowed both portfolios to easily beat the market's performance since their inception in 2001.

A lesser known feature of StockInvestor is Red Flags. In each monthly issue we highlight three companies that we believe investors should be very wary of. The qualities we look for in a company before featuring it in Red Flags are exactly the opposite of the qualities of the stocks owned in the Tortoise and Hare portfolios. Companies that make it to our Red Flags feature tend to have:

  • No economic moat.
  • Above-average risk.
  • A relatively poor Morningstar Stewardship Grade.
  • A stock trading well above our estimate of its intrinsic value, e.g., a low Morningstar Rating for stocks.

The more of these qualities a company has, the more likely we will feature it as a Red Flag. Though we have had a couple of companies see their stocks go up after we highlighted them, we have also had a fair share of warnings that would have--if heeded--saved investors a lot of heartache. In the past year alone, we featured Delphi (DPHIQ),  Calpine (CPNLQ), and Delta Airlines (DALRQ) as Red Flags before each declared bankruptcy and saw their stocks precipitously decline.

Below are three companies we highlighted as Red Flags in recent past editions of StockInvestor. Though these stocks could very well bounce, none will make for good long-term investments, in our opinion. We simply think there are companies in the market that offer far better risk/reward propositions today.

Trans World Entertainment (TWMC)
Rating: 3 Stars
Economic Moat: None
Risk: Speculative
Stewardship Grade: F
From our  Analyst Report: "Trans World Entertainment is a music and video retailer that operates mall-based and free-standing stores under names such as FYE, Coconuts, and Strawberries. In today's fiercely competitive retail environment, pure-play music and video retailers like Trans World are facing an uphill battle, and we don't like its long-term prospects. Trans World sells commodity products and competes with some of the most feared retailers, including  Best Buy (BBY),  Wal-Mart (WMT), and  Amazon.com (AMZN). Additionally, rampant music piracy and the advent of legitimate music downloads (e.g.,  Apple's (AAPL) iTunes music store) have been a drag on CD sales. Trans World has no long-term competitive advantage, and the competition continues to eat away at its market share."

US Airways (LCC)
Rating: 1 Star
Economic Moat: None
Risk: Speculative
Stewardship Grade: B
From our  Analyst Report: "Let's get one thing straight: Newlywed US Airways is not a low-cost carrier, no matter what its ticker suggests. Despite its newfound financial stability and some favorable near-term industry trends, US Airways cannot escape its poor business fundamentals. Considering the airline industry's history of value destruction and Morningstar's long-term, intrinsic value investing philosophy, we spend what may be inordinate time and effort evaluating the outlook for these businesses. What reason do we have to believe that the future will be different than the past? None. Near-term fluctuations in such factors as fuel costs, passenger demand, and fares will always make for plentiful speculative opportunity, but the industry's underlying fundamentals indicate extraordinarily slim operating profits in the long run."

Stolt Offshore (SOSA)
Rating: 1 Star
Economic Moat: None
Risk: Above Average
Stewardship Grade: D
From our  Analyst Report: "Stolt Offshore is enjoying the benefits of tight energy markets around the world. But despite near-ideal current conditions, we are convinced Stolt Offshore will rarely, if ever, earn its cost of capital, and we recommend investors avoid the stock until it is available at a deep discount to our fair value estimate. Plus, for our fair value estimate to match the current stock price, we would need to assume in our discounted cash-flow model that revenue will grow at a 27% annual clip over the next five years. We believe this is highly unlikely."

Paul Larson does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.