"Sell in May and go away" is a well-known and well-heeded Wall Street axiom. Starting in 1950, if you invested in the
Dow Jones Industrials
every year on May 1 and sold on Oct. 31, you'd actually have a loss, according to the
Stock Trader's Almanac
As we approach a historically difficult time for the market, it's an opportune moment to search for stocks that are better off being sold than bought.
I took a quantitative approach to start the research for some new ideas, thereby eliminating any of my own biases. Using Morningstar's premium stock screen, I started with stocks that had at least a $300 million market cap.
From there I wanted to see companies that had positive net income growth with declining cash flow from operations. Earnings can be doctored much more easily than cash flow, and that combination can be an early warning sign that net income growth will deteriorate or turn negative.
Other areas I screened for:
- Lower inventory turnover: Companies that are turning over their inventory at lower rates are not optimizing their capital, as it is tied up in product that is sitting on the shelves.
- Higher days sales outstanding: DSOs are a measure of account receivables. Higher DSOs show that a company is not converting its sales to cash in an optimal manner. It can also be an indicator that a company is stuffing the channel if it rises disproportionately to sales.
I also looked for companies with shrinking gross profit margins and price-earnings-to-growth ratios that were higher than the sector average.
My screener spit out the following eight stocks, which are shown here along with how many analysts rate each security a buy, sell or hold.
As you can see, of the eight, only
has a strong bullish bias. Being a self-proclaimed contrarian, I'm particularly wary of stocks the rest of the Street is still positive on. If most of Wall Street hates a stock that is a short candidate, chances are that much of the downside has already been realized.
So let's take a closer look at Kellogg, which was recently down 0.8% to $43.44 after a downgrade by Goldman Sachs. The stock has downside risk to $40, in my opinion, on the basis of both technical and fundamental factors.
In 2005, Kellogg's net income rose to $980.4 from $890.6 million in 2004, aided by lower interest and income tax expense and a 5.8% sales increase. Cash flow from operating activities dropped to $1.14 billion from $1.23 billion as accounts receivables rose sharply and capital expenditures increased.
While Kellogg is no doubt one of the leaders in packaged cereals and snacks, sales growth is expected to slow to 3.9% in 2006, according to First Call consensus estimates.
The company is also facing a few headwinds when it comes to earnings. Sugar costs hit their highest level in 17 years last week. Additionally,
is attempting to run an even more efficient operation by keeping inventory as lean as possible. That will force vendors such as Kellogg to revamp operations and keep more inventory on their own shelves. Any hiccup in the process could cause significant problems for Kellogg, as Wal-Mart is the company's largest customer and represents 17% of total sales.
Lastly, the expansion of private-label brands is growing rapidly. Consumers realize that the quality of store-brand products is usually just as high as that of brand-name products, but at a significant discount. Kellogg will increasingly have to find ways to differentiate its products from the store brands.
Operating profits are expected to grow just 3.3% in 2006 and shrink by half a percent in the first quarter; Kellogg reports on April 27. The expected decline in operating profits is attributed to higher energy and commodity costs. Should those costs remain high throughout the year, it is likely that the analysts' full-year consensus earnings per share estimate of $2.50 will have to come down.
According to Reuters, Kellogg's five-year EPS growth rate is 10.25%. However, EPS is expected to grow significantly below that figure over the next two years -- and that's with the high level of optimism from the Street. Should commodity costs continue to rise, sales falter or margins get squeezed further by Wal-Mart, earnings growth could slow to a crawl. In my opinion, paying nearly two times growth seems a bit rich.
The technical picture of Kellogg is worsening. The stock recently made a lower low and a lower high. Despite a strong market over the past several months, Kellogg's stock has gone virtually nowhere. The share price is now below its 200-day and 50-day moving averages, another bearish sign.
Brad Wallick, chief global technician with MKM Partners, first put out a bearish note on Kellogg in November. "Kellogg was the one I got a lot of pushback on," he said. The bullish sentiment but lack of positive price action should give bears more confidence in their opinions. Incidentally, Wallick is negative on the entire packaged-foods group, but he stresses that Kellogg is the prime suspect to head lower.
Wallick expects Kellogg to fall through support at $42 and make its way down to $40, the same price target I mentioned above.
Considering the high degree of optimism, the obstacles to greater sales and profits and the technical picture, don't expect Kellogg shares to snap, crackle or pop anytime soon.
In keeping with TSC's editorial policy, Lichtenfeld doesn't own or short individual stocks. He also doesn't invest in hedge funds or other private investment partnerships.
Marc Lichtenfeld was previously an analyst at Avalon Research Group and The Weiss Group and a trader at Carlin Equities. He holds NASD 86, 87, 7 and 63 licenses. His prior journalism experience includes being a reporter/anchor for On24 in San Francisco and a managing editor of InvestorsObserver, a personal finance Web site. He is a graduate of the State University of New York at Albany. He appreciates your feedback;
to send him an email.