Danger: These Stocks Contain Hidden Bombshells

If you're lucky, stocks warn you of their dangers upfront.  

Post-bubble, every armchair stock picker can spot the lingering danger in homebuilders. Like the packages containing its tobacco products, Altria virtually screams its litigation risks in a big, bold point size. And the 2009 bankruptcy of GM serves as an easy object lesson for what can go wrong in the globally cutthroat, capital-intensive car industry.

Believe it or not, homebuilders, tobacconists, and car manufacturers are relatively easy to dissect. We know that we have to factor in a discount to make up for the uncertainty in housing, litigation, and consumer demand for American-built cars.

As with people, it's the quiet ones lurking in the corner you have to worry about. The companies that seem to report all the right things just may be hiding serious bombshells. These are the ones that can shatter your returns and cripple your retirement savings.

Allow me to explain with a few examples.

Bombshell No. 1: The trumped-up dividend
Few things in investing give folks more comfort than a warm dividend stream. And the bigger, the better. When a company sends you money regularly, you can see the tangible gains from your investments. And unlike earnings (or even free cash flow), dividends can't be manipulated.

Or can they?

Well, in an ideal world, a company does well for itself and turns a nice profit. It then shares some of these profits with shareholders through dividends. But a company can also get its dividend money from less impressive sources than earnings. It can borrow more money from banks or bondholders. Or it can float new shares in the company. The former increases bankruptcy risk; the latter dilutes your stake in the company.

Of course, some companies have no choice. Mortgage REITs have to return 90% of their profits to shareholders to keep their tax-efficient REIT status. So it's not necessarily a red flag that over the past three years, 15.6% dividend payer Resource Capital (NYSE: RSO  ) brought in twice as much cash from stock sales as it paid out in dividends. Or that the figure for 18.8% payer American Capital Agency (Nasdaq: AGNC  ) is more than 10 times. Since they can't meaningfully reinvest their profits, selling more shares or leveraging up is what they have to do when they want to invest for growth. And, passing the initial growth test, sales and profits have been growing for each.

But when you're not a REIT and your sales and profits have been tanking, it's a major danger sign when stock sales outpace dividends. Look no further than Nordic American Tanker Shipping (NYSE: NAT  ) for this scenario. In its past five full fiscal years, it has paid out a hefty $571 million in dividends. That's more than its net income total or its free cash flow total. But it's not more than the $940 million in stock it floated. That's why I don't find its 5.3% dividend yield compelling at all.

Bombshell No. 2: Hidden balance-sheet gremlins
With the rise of 401(k)s, many investors don't even think about the risk that unfunded pensions cast over companies. Warren Buffett once wrote: "There is already far more debt in corporate America than is conveyed by conventional balance sheets. Many companies have massive pension obligations geared to whatever pay levels will be in effect when present workers retire."

Look no further than the defense industry for examples. Already, highly leveraged players Lockheed Martin (NYSE: LMT  ) (133% debt-to-equity) and Boeing (NYSE: BA  ) (292% debt-to-equity) juice those debt obligations with comparable to more-than-comparable underfunded pension amounts. It's a similar story on a smaller scale at Rockwell Collins (NYSE: COL  ) , whose leverage isn't as low as its 34% debt-to-equity ratio would indicate.

Bombshell No. 3: Deceptively low P/E ratios
Value investors are taught over and over again to be greedy when others are fearful. As Greece faces an acute debt crisis, the market's definitely fearful of Greek banks. Some investors, hoping to take advantage, are looking into National Bank of Greece (NYSE: NBG  ) , which continues to be profitable through it all. The market is assigning it a P/E ratio of 8.2 and a price-to-book ratio of 0.5. Both of those ratios are dirt cheap, but to blindly throw money at low multiples can be a huge mistake.

Take the time to assess the magnitude of its potential bombshell: National Bank of Greece's gross exposure to government bonds is 218% of its book value. In other words, any negative events for Greek debt (not just outright default) can have a crippling effect on NBG.

That doesn't mean NBG won't prove to be a profitable greedy-when-others-are-fearful situation (I continue to monitor it as its stock price slides), but throwing money at a stock without assessing the potential bombshell is gambling, not investing.

The same goes for all these hidden bombshells. We need to be brutal when we think through possible downsides to make sure we're not overpaying on optimism. That's why, when I recently made a stock recommendation, I started my write-up by listing 10 reasons you shouldn't buy the stock. You can see my stock pick and four others by downloading our free report: "5 Stocks The Motley Fool Owns -- and You Should Too."

 Anand Chokkavelu owns shares of Altria, GM, and Lockheed Martin. The Motley Fool owns shares of National Bank of Greece, Lockheed Martin, and Altria Group. Motley Fool newsletter services have recommended buying shares of General Motors. Try any of our Foolish newsletter services free for 30 days. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (25) | Recommend This Article (84)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 21, 2011, at 10:33 PM, Shawnerz wrote:

    Anand,

    What the heck does this mean?

    "Already, highly leveraged players Lockheed Martin (NYSE: LMT ) (133% debt-to-equity) and Boeing (NYSE: BA ) (292% debt-to-equity) juice those debt obligations with comparable to more-than-comparable underfunded pension amounts. It's a similar story on a smaller scale at Rockwell Collins (NYSE: COL ) , whose leverage isn't as low as its 34% debt-to-equity ratio would indicate"

    OK, I get "highly leveraged." They borrowed a ton of money. But what does this mean?

    "...juice those debt obligations with comparable to more-than-comparable underfunded pension amounts"?

    -Shawn

  • Report this Comment On June 22, 2011, at 9:27 AM, TtheTA wrote:

    Shawn, Anand is saying that since those companies have large underfunded pension plans, they effectively have more debt (the amounts owed to their pension plans) than is included in the traditional debt/equity ratio. He is proposing that you should re-do the ratio calculation to include the pension obligation as debt.

  • Report this Comment On June 22, 2011, at 12:54 PM, QuickClickSell wrote:

    Informative article.

    I also have a question. You wrote: "National Bank of Greece's gross exposure to government bonds is 218% of its book value. "

    How did you come up with 218% of book value? Does that mean they'll owe money if the bonds collapse? I'm not an accountant by any measure, but this doesn't make sense to me. Wouldn't it be a percentange up to 100%?

    Are you saying they used borrowed money to buy government bonds?

  • Report this Comment On June 22, 2011, at 1:00 PM, TMFBomb wrote:

    @QuickClickSell,

    Remember that book value is what's left when you subtract liabilities from assets. So assets (including government bond holdings) can be much larger than book value.

    Here's my source:

    http://online.wsj.com/article/SB1000142405270230371470457638...

    Fool on,

    A

  • Report this Comment On June 22, 2011, at 1:34 PM, Katommy wrote:

    BA and LMT do have underfunded pension plans. Fortunately or unfortunately, depending on your perspective, the govt. will bail much of it out where those plans impact govt. contracts. While with NASA, we had the same situation with Rockwell, United Space Alliance, and other large contractors. We were essentially forced to fund these large obligations to keep our contractors whole through the end thier respective technical programs. So I'd discount that aspect of the balance sheet.

  • Report this Comment On June 22, 2011, at 4:15 PM, mikecart1 wrote:

    People have been talking bad about MO for years. If you listened to these people in 2009, you would have missed 100% returns. I'm swimming in mad cash and I own a ton of MO. The connection is more clear than OJ and a glove.

  • Report this Comment On June 22, 2011, at 6:17 PM, 1caflash wrote:

    I agree with mikecart1 about MO. AGNC is offering about 42 million more shares which will dilute its sharecount to a bit over 170 million. Expect the dividend to be cut eventually. This will give AGNC more firepower to obtain additional bargains in its business. Great timing! Let's see if the day-traders give us fine prices so we can add to our holdings. MO and AGNC are in my DRIP.

  • Report this Comment On June 23, 2011, at 11:06 AM, TMFBomb wrote:

    @TtheTA,

    Thanks for explaining.

    @Katommy,

    Good examples to keep in mind!

    Fool on,

    Anand

  • Report this Comment On June 24, 2011, at 11:13 AM, poneman wrote:

    I always find it fascinating when two articles on the same stock (NAT) come out on the same day - one touting the dangers of hidden bombshells while the second article lists NAT as one of the "favorites" of Jim Kramer.

    Not that Jim Kramer knows all, but it is funny how two guys can look at the same stock and have completely different views.

    While I'm not sure about NAT, I'm also not sure I understand what the author is saying when he says:

    "In its past five full fiscal years, it has paid out a hefty $571 million in dividends. That's more than its net income total or its free cash flow total. But it's not more than the $940 million in stock it floated. That's why I don't find its 5.3% dividend yield compelling at all".

    What do the last two lines mean? That the hidden bombshell isn't as bad as one might think (despite dividend outpacing net income and free cash flow) because the dividend did not outpace the value of the stock?

    Compelling? You don't find the dividend compelling? In other words, it should intrigue you but doesn't because of the other dangers?

    Can somebody help me

  • Report this Comment On June 24, 2011, at 11:31 AM, DYCRIL wrote:

    I still feel that MLPs are the safesst and most rewarding with their dividends and capital maintenance.....Prescott Bill

  • Report this Comment On June 24, 2011, at 11:56 AM, sept2749 wrote:

    OK, OK anyone got a cigarette? I don't care what they cost and I don't give a hoot about the dangers. I just need a smoke now!

  • Report this Comment On June 24, 2011, at 12:47 PM, CGURSCHE wrote:

    @poneman, selling stock to fund a dividend payout is, in effect, a Ponzi scheme. Current investors are being paid out of new investors' money, the company itself not earning enough to cover it's "obligations."

    Having said that, it differs from a Ponzi scheme in that the company can cut or eliminate the dividend at any time, which it will have to do. If your reason for buying the stock was the dividend, you'll be disappointed when it disappears. If you then sell, as others are sure to, the share price will drop. Boom!

  • Report this Comment On June 24, 2011, at 12:48 PM, TMFBomb wrote:

    @poneman,

    I can't speak for Jim Cramer's thoughts, but what I was pointing out is that NAT's dividends have not been funded by profitability but rather floating more shares (at least in recent years). Therefore, I don't find the dividend compelling -- i.e. I'm steering clear of it.

    Hope that clarifies.

    -Anand

  • Report this Comment On June 24, 2011, at 12:49 PM, TMFBomb wrote:

    @CGURSCHE,

    Thanks...we were writing at the same time!

    -A

  • Report this Comment On June 24, 2011, at 1:01 PM, shnook91 wrote:

    @poneman - I don't follow Cramer but when dividends are funded by issuing new shares and not FCF or Net Income then the dividend cannot continue to be paid. We're left to decide whether income will increase quickly enough to cover the dividend or whether the dividend will eventually be cut to match the new expected earnings. Cheers

  • Report this Comment On June 24, 2011, at 1:07 PM, buynholdisdead wrote:

    @TMFBOMB

    NBG is certaintly a very risky stock but there is a few things that are happening that make you think.

    NBG is planning on selling 20% of its Turkish bank unit Finansbank to raise its capital tier 1 ratio to above 13%. While its good to have the liquidity its not good that they are selling one of their fastest growing assets.

    Also Greece is a bombshell for the whole western world and the United States Financial system is going to take a big hit if Greece does a hard default. One thing I do not understand Anand is if someone is buying bonds from Greece, and then goes out and buys insurance on default of those bonds. If a default occurs how that will play out.

    Here is an article that discusses that.

    http://streetlightblog.blogspot.com/2011/06/betting-on-pigs....

    Andy

  • Report this Comment On June 24, 2011, at 3:51 PM, poneman wrote:

    Thanks to all for your responses. It makes sense, although the fact that the company keeps increasing it's fleet and adding new sources of income and revenue should help.

    I've held NAT for over 10 years and the dividend performance has been excellent.

    Not happy with the recent stock performance, but I think the entire sector has been down for the last couple of years. When rates go back up (hopefully), the companies will see more profit.

  • Report this Comment On June 25, 2011, at 12:36 PM, Roobeans wrote:

    I'm not really understanding the comments on Lockheed Martin (LMT). First of all, a recent Motley Fool article written by Dan Caplinger says that LMT is the "right stock to retire with" and rates it 8 out of 10: http://www.fool.com/retirement/general/2011/03/29/is-lockhee... Secondly, the Free cash flow payout which comes out to only 36% is more than sufficient to handle LMT dividend.

  • Report this Comment On June 25, 2011, at 12:42 PM, Roobeans wrote:

    The comments on BA would be correct in that they have not only a large D/E ratio but negative cash flow. Could be the same with LMT but the figures I'm seeing, plus the article by Caplinger, make me think otherwise for LMT.

  • Report this Comment On June 26, 2011, at 12:30 PM, ssg13565 wrote:

    The people who buy Greek debt and then buy insurance on that debt are playing the same game as a few hedge fund managers did during the real estate bubble.

    They had detected that the house of cards was very vulnerable to even a slight slowdown in the real estate market.

    The bought as much insurance as they could from AIG because they new the insurance was way under priced. I am not sure how they expected AIG to pay for its mistake when it all hit the fan. I guess they "lucked out" when the government rescued them by making good on AIG's insurance product that they could not make good on.

    When Greece finally defaults are the insurance buyers sure that the insurance company has the wherewithall to pay? Or are the betting that they will get bailed out again?

  • Report this Comment On June 27, 2011, at 12:30 PM, poneman wrote:

    Anand,

    FYI: Jim Kramer read your article about NAT and has written a direct response to your findings. Since I don't subscribe to "The Street", I could not read the entire article.

    However, I'm sure you would want to read it to see what he is saying.

    Thanks,

    Greg

  • Report this Comment On June 28, 2011, at 2:08 AM, Lordrobot wrote:

    Anand, you may need a good lawyer.

    If I were NAT I would initiate a suit against you and they would win per se. Judging from the activity of the stock over the last week, it is safe to say your reckless article created a dangerous sell off and no doubt some traders acted on your article apparently in advance and after publication.

    When did you publish this article and who had a look at it before it was published? Who did you talk with? I think it is safe to say that the stock was selling off prior to your article release. I suspect its contents were leaked.

    Remember as a CFA, you have a fiduciary duty not only to clients but to the rules of professional responsibility of that profession.

    What you have accused NAT of doing is literally a Ponzi scheme. You have accused management of committing a Federal Crime involving dishonestly which if true would send them to jail, destroy their reputations, and remove them from any participation in management of a publicly traded company. It has nothing to do with your intent. It is the end result. That is why this is defamation per se. You said it and that is enough.

    You claim the company net earnings and cash flow for the last five years were inadequate to pay the dividend and the div was paid for by floating new stock. Yet these charges you make are disputed in ever public filing as well as certified accounting records. As a CFA, you will be held to a higher standard of conduct. Thus when you accuse a company of a Ponzi scheme, the assumption is that you have done a thorough investigation.

    NAT has paid from cash flow and the equity offering was in fact used to increase ship buildout without accruing any debt. But you have slanted the reality to imply a full blown ponzi scheme.

    Your article forced the company to issue a response to the criminal charge you have levied. You have libeled management, the company, the board of directors with your per se charge. As for damages, I think it is safe to say there are plenty.

    Many traders who may have used stop looses may have had their positions sold off with your reckless article. The reputation of the management is a per se defamation case. You have harmed them professionally to the extent that they had to immediately defend themselves and the company from your charges.

    Anand, I strongly advise that you seek the advice of counsel and fashion a very complete retraction and apology.

    Freedom of speech is a wonderful privilege and it allows opened discourse in political matters. But commercial speech is regulated. You can't yell fire in a movie theater if there is no fire. People could get hurt trying to escape. You can't recklessly attack people engaged in a profession without first knowing the law, knowing the limits of speech, and having your facts completely in line.

    My guess is that with the movement of NAT shares over the last several weeks that you and perhaps some of your clients and associates will be investigates by Federal Authorities.

    When you accuse someone of a Federal Crime you open the door to the same levels of attack as you have deployed. With your article you thrust yourself into the limelight at the expense of the character and honesty of others. I fear you are about to learn a very brutal but perhaps deserved lesson,

    You got your 15 minutes of fame pal with this one. What were you thinking? Do you think just because you didn't directly say "ponzi scheme" that you didn't commit defamation? It is my opinion that you have stepped over the line and have caused a lot of trouble for the company. I am pretty sure that the Motley Fools will be talking to Counsel of their own especially since they have published you multiple times.

  • Report this Comment On June 28, 2011, at 3:11 PM, capalligator wrote:

    The Number from sources beleived to be accurate:

    Dividends paid ('06,'07,'08,'09,'10): $570.9 million

    Net Cash from Tot Oper Activites: $439.1 million

    Dividends p/sh ('06,'07,'08,'09,'10): $18.75

    Cash Flow p/sh: $14.03

    It appears as though 23% of the dividend, on average, is essentially comming from financing activites.

    Anyone have numbers from Cramer or NAT?

  • Report this Comment On June 28, 2011, at 3:20 PM, capalligator wrote:

    Detailed figures:

    Yr DivPd OpRev Net$TOA CFp/sh DIVp/sh

    06 $122.6 $175.5 $106.6 $3.61 $5.85

    07 $107.3 $187.0 $ 83.6 $2.91 $3.81

    08 $165.9 $228.0 $127.9 $4.86 $4.79

    09 $ 95.4 $124.4 $ 63.2 $1.33 $2.35

    10 $ 79.7 $126.4 $ 57.8 $1.32 $1.45

    5Y $570.9 $841.3 $439.1 $14.03$18.25

  • Report this Comment On June 30, 2011, at 12:33 AM, randymasker wrote:

    Lordrobot,

    Have you read what you wrote? You sound like a teenager girl ranting on and on and on and on.... You and everyone else needs to do their own

    DD instead of selling (or buying) a stock because of what someone wrote. This is intended to give you ideas for you to investigate ON YOUR OWN!!! It would be different if you paid for this persons research, did you or anyone else pay for this information did they? I thought that it was just his opinion, didn't you?

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