One of the tools I use when I invest is the Berkowitz kill list, which covers a short collection of things that companies do that frequently lead to poor investor returns -- or worse. Verizon Communications Inc. (NYSE: VZ), Energy Transfer Equity (NYSE: ETE), and Foresight Energy LP (NYSE: FELP) all meet at least one important "kill" criterion. Some investors might consider one or more of these companies to be top stock picks, but my analysis suggests they are terrible stocks you'd be better off avoiding. Here's why.
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Kill the company
When I see an investment "tool" that makes sense I try to add it to my investment toolbox. Which is why every stock I look at gets subjected to Fairholme Fund manager Bruce Berkowitz's "kill list." Essentially, it's a short list of things that companies frequently do that lead to trouble. What I really like about the list, however, is that it's easy to use and forces you to question your assumptions. Here's my version of the Berkowitz "kill list":
|My Bruce Berkowtiz Inspired "Kill List"|
|1.They don't generate enough cash|
|2.They burn too much cash|
|3.They have too much debt|
|4.They take big risks (playing Russian Roulette)|
|5.They have bad management|
|6.They have bad boards|
|7.They expand into inappropriate areas (diworsification)|
|8.They buy stock back at premium prices|
|9.They lie with GAAP accounting|
No company is perfect, but if one I'm looking at raises a red flag on this list I step back and question my assumptions. Which is exactly why Verizon, Energy Transfer, and Foresight Energy are all stocks I'd avoid -- each fails at least one of my Berkowitz "kill list" tests.
Sometimes companies make acquisitions that just don't pan out. Often, such investments are questionable from the start. There's a name for such a situation: diworsification. And it's my big concern with Verizon.
Image source: Foresight Energy LP
On the surface, Verizon would be a great investment, especially because I'm a big fan of dividends. After all, the telecom is one of the largest cell-phone companies in the United States, it's increased its dividend for 12 consecutive years, and it offers a hefty 4.75% yield. But I just can't bring myself to like what's going on today.
For starters, the company's core cell-phone business is mature. That means it's in a fight for market share, with smaller players making aggressive price moves to win customers over. Since cell service is largely a commodity, that leaves Verizon's pricing power in the hands of its weakest competitor. Not a good thing -- but alone not a reason to avoid Verizon.
My diworsification concern is that the telecom giant is using acquisitions to reach into the content space -- notably, purchasing struggling internet companies. Sure, AOL, a recent purchase, had material early success, but it's been all downhill since that company's merger with, and subsequent separation from, Time Warner. And that isn't the only internet also-ran Verizon is looking at. At best, I think Verizon will have to spend a lot of shareholder cash to make the content push work. At worst, it will be a complete waste of time and money. I could be wrong, but I'm definitely not willing to take on the risks of diversification failure here.
Bad board, bad management
Midstream giant Energy Transfer fails what really amounts to a corporate-integrity test. Here's the recap: A couple of years ago, Energy Transfer tried to acquire competitor Williams Companies. With oil prices falling precipitously at the time, it quickly turned into a bad decision that would probably have required cutting the dividend, taking on huge amounts of debt, or issuing dilutive shares to complete as originally designed. Energy Transfer worked hard to scuttle the deal.
The promised synergies of the Williams acquisition never panned out in this now scuttled deal. Image source: Energy Transfer Equity.
That was probably the right thing for shareholders. But there was a little wrinkle in that not-so-distant drama that should still worry investors today. Part of the effort to get out from under the Williams deal involved the issuance of convertible securities, a large portion of which went to Kelcy Warren, the CEO and chairman of the board. These securities would have, effectively, protected the CEO's distributions if the deal were consummated and the common dividend were cut. In other words, the company's choice was to protect its most prominent insider from a worst-case scenario.
Since Warren is still the CEO and chairman, I'm not willing to go near Energy Transfer. No company is a perfect citizen, but that convertible sale is just too much for me to overlook.
Too much debt
Foresight Energy is a lot easier to get your head around. This coal miner has struggled through the coal industry downturn, as all coal miners have. And to its credit, it has managed to avoid bankruptcy -- unlike some of its larger peers. However, it has only managed to do so because its creditors have been working with it to ensure it stays out of bankruptcy court.
The big push came in 2016 with what the company called a "global restructuring," but there are still follow-up transactions taking place. To give you an idea of just how bad it is, debt makes up more than 100% of Foresight's capital structure, because there's a limited partner deficit. It's so bad that the partnership no longer pays a distribution, which is kind of a telling sign for a corporate structure that's meant to pass income through to unitholders.
There are better options in the coal space if you think the sector is ready for an upturn.
Simple rules can save you
Investing can be pretty complex, but there are times when simple little rules can help you avoid risky choices. That's the point of the Berkowitz kill list, which includes avoiding diworsification, bad management and boards, and overly indebted companies. These not-so-little red flags trip up Verizon, Energy Transfer, and Foresight Energy, respectively. I wouldn't touch these stocks right now, and I'd suggest you don't either.
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