10 Dow Stocks Investors Should Avoid

This article was originally published on June 25, 2010 -- updated on July 29, 2010 and most recently updated on September 9, 2010.

NEW YORK (TheStreet) -- For some reason, investors choose to value stocks using fairly meaningless criteria. What's the 10-day simple moving average? Earnings per share? Beta?

Who cares? These are the tools of the trader -- not an investor.

If you were asked to become an investor in a small, privately owned business, one question would probably cross your mind: How long until I get my money back?

Now that's a question worth asking, and the same holds true for investing in publicly traded companies. Because many public companies hold debt on their balance sheets, it's important to expand the question to arrive at a useful conclusion:

If I bought this company, assumed all its debts and then collected 100% of profits from now until forever, how long would it take to make my money back?

Liability-Adjusted Cash Flow Yield (LACFY) is your answer, and might be the most useful (and least common) fundamental valuation technique. LACFY is defined as the following:

10-Year Average Free Cash Flow / (((Outstanding Shares + Options + Warrants) x (Per Share Price) + (Liabilities)) - (Current Assets - Inventory))

For a savvy stock-picker who abides by Benjamin Graham's margin of safety principle, comparing LACFY to the yield on a 10-year Treasury is a starting point for success. Using this valuation technique on the 30 stocks that comprise the Dow Jones Industrial Average, we've arrived at the 10 most overpriced Dow stocks that should deliver disappointing returns for buy-and-hold investors:

10. Chevron

• Liability-Adjusted Cash Flow Yield: 3.4%
• 10-Year Treasury Yield: 2.76%
• Graham Margin of Safety Ratio: 1.23 (a ratio greater than 2 is desirable)
• Return on Invested Capital: 6%

Of all the integrated oil majors, Chevron(CVX) is near the top in terms of valuation and profitability, but it's worth noting that every integrated oil company pales in comparison to Exxon Mobil(XOM).

With a LACFY of 5.3% and a 12% return on invested capital, Exxon is twice as profitable as Chevron, and more attractively valued.

9. Verizon

• Liability-Adjusted Cash Flow Yield: 3.3%
• 10-Year Treasury Yield: 2.76%
• Graham Margin of Safety Ratio: 1.2
• Return on Invested Capital: 5%

The smartphone boom may not be a boon for telecom investors. Unless advances are made in data compression technologies, data providers such as Verizon(VZ) will be forced to make frequent and expensive improvements to their infrastructure (resulting in a low return on invested capital).

The elimination of unlimited data plans should help to rein in costs, but investors shouldn't expect much growth from Verizon. Investors attracted to Verizon's 6.4% dividend yield should look to the company's senior bonds as a safer income play.

8. AT&T

• Liability-Adjusted Cash Flow Yield: 3.1%
• 10-Year Treasury Yield: 2.76%
• Graham Margin of Safety Ratio: 1.12
• Return on Invested Capital: 5%

AT&T(T) has enjoyed top-line growth in recent years thanks to its exclusive deal to carry the iPhone in the U.S, but further share-price appreciation should not be expected. The iPhone provider sports a near-identical valuation as rival Verizon and faces industry headwinds.

Smartphone innovation will continue to place pressure on AT&T to upgrade its infrastructure, requiring large capital expenditures (resulting in less free cash flow for shareholders).

AT&T was recently placed on "credit watch negative" by ratings agency Standard & Poor, raising the possibly of a credit downgrade (a scenario that could result in operational deficiencies).

7. Kraft

• Liability-Adjusted Cash Flow Yield: 2.7%
• 10-Year Treasury Yield: 2.76%
• Graham Margin of Safety Ratio: 0.98
• Return on Invested Capital: 4%

Trapped inside of Kraft Foods(KFT) are dozens of wonderful companies trying to escape. Sadly, Kraft is the Galactus of the food industry and continues to swallow smaller entities. Make no mistake, there are oodles of value inside of Kraft, but rather than focusing on profitability and value recognition, management chooses to acquire new companies. Buffett was right to be annoyed and has continued to lighten his position in the packaged food giant.

Kraft would be wise to trim its dividend, pay down an ever-increasing debt load and refine internal processes until its dreadful returns on invested capital are at least doubled. Given Kraft's size, it will take many years to right this ship, and management has made no indication that it intends to do so.

6. Bank of America

• Liability-Adjusted Cash Flow Yield: 2.4%
• 10-Year Treasury Yield: 2.76%
• Graham Margin of Safety Ratio: 0.87
• Return on Equity: 4%

Bank of America(BAC) is a better-than-average bank with less-than-average investment potential. If you're absolutely dying to add a bank (or banks) to your portfolio, preferred shares can offer a respectable stream of income without the risk of common-equity dilution (but preferred shares still carry numerous risks). BofA's preferred shares can be accessed through several ETFs. The PowerShares Financial Preferred(PGF) and PowerShares Preferred(PGX) are two such funds.

5. McDonald's

• Liability-Adjusted Cash Flow Yield: 2.5%
• 10-Year Treasury Yield: 2.76%
• Graham Margin of Safety Ratio: 0.91
• Return on Invested Capital: 10%

Despite a lofty high valuation, it's tough to short-sell McDonald's(MCD). Mickey D's is among the most profitable restaurant franchises in the country and continues to offer consumer-friendly products at the right price.

Then again, McDonald's management willingly chose to divest from Chipotle -- one of the fastest-growing restaurant franchises of the decade. At today's valuation, McDonald's isn't a buy, but may fall into the category of an indefinite hold.

McDonald's stock fell from an all-time high on Thursday after the company reported disappointing European sales.

4. JPMorgan Chase

• Liability-Adjusted Cash Flow Yield: 2.3%
• 10-Year Treasury Yield: 2.76%
• Graham Margin of Safety Ratio: 0.83
• Return on Equity: 4%

JPMorgan Chase(JPM) is the best of a bad lot. The function of a bank is to allocate capital and manage risk -- two things that no large financial institution has done well for some time. Worse yet, financial institutions have a long history of rewarding management while diluting shareholders through numerous equity offerings -- this is poison for long-term investors.

In the opinion of this author, buy-and-hold investors should avoid bank stocks entirely. The banking industry is extremely competitive, susceptible to macroeconomic events and relies on human capital for competitive advantages. The odds are not in your favor.

3. Wal-Mart

• Liability-Adjusted Cash Flow Yield: 2.1%
• 10-Year Treasury Yield: 2.76%
• Graham Margin of Safety Ratio: 0.76
• Return on Invested Capital: 6%

In 2001, growth-hungry investors bid Wal-Mart's valuation to a nosebleed-inducing 39.8 P/E. The company responded with 10 years of spectacular earnings growth that fell way short of expectations. The stock has flat-lined for a decade and serves as a valuable reminder: rate of return is directly correlated to price paid.

Today, Wal-Mart(WMT) is a lumbering giant facing labor disputes, razor-thin margins and mountains of debt.

2. Caterpillar

• Liability-Adjusted Cash Flow Yield: 2%
• 10-Year Treasury Yield: 2.76%
• Graham Margin of Safety Ratio: 0.72
• Return on Invested Capital: 8%

Caterpillar(CAT) stock is not for the faint of heart. The heavy-industry titan has historically outperformed the Dow, but I doubt many investors stuck around for the ride. In March 2009, CAT plummeted to less than $25 per share -- then rebounded for an explosive 300% gain.

At today's valuation, Caterpillar stock offers investors no compelling reason to buy (but may continue to provide speculators and traders with mouth-watering gains). Caterpillar's second-quarter results bulldozed analyst's expectations, but worries persist on the company's incremental margins.

1. Alcoa

• Liability-Adjusted Cash Flow Yield: 0.7%
• 10-Year Treasury Yield: 2.76%
• Graham Margin of Safety Ratio: 0.25
• Return on Invested Capital: 1%

Alcoa(AA) is a cyclical materials stock caught in a death spiral. The once-maker of Reynold's Wrap aluminum foil has ugly earnings, an ugly chart and ugly health care liabilities. Opportunities may abound here for technical traders, but for long-term investors, the future of Alcoa is very much uncertain.

-- Written by John DeFeo in New York CityFollow @johndefeo

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