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With the Australian sharemarket poised for another six months of volatility, steering clear of wealth-eroding companies requires greater effort than it did during the market’s 16-year bull run.

But until the full impact of the economic slowdown on equities is known, sniffing out tomorrow’s dead-beats remains somewhat of an art. A back-to-basics review of company fundamentals and key market indicators should reveal the companies and sectors that are best avoided.

According to Matt Hollyman client adviser with ABN Amro, if a stock looks and barks like a dog, there’s a strong likelihood it has the ‘mark of the pooch’ about it.

He says classic hallmarks of stocks destined to languish on the ASX are poor liquidity and earnings, low stock volumes (making it difficult to buy and sell), and sectors marginalised by either structural and regulatory shifts or technological and competitive forces.

Hollyman says investors can’t intelligently decide which stocks to avoid until they’ve worked out how long they plan to hold a stock. Bank stocks, are a case in point. Is a bank trading on a multiple of 12x attractive? The answer to this question hinges on an investor’s time horizon and their appetite for risk. “While investors should own banks, there’s no real rush to buy now,” advises Hollyman.

Clearly, there’ll always be ‘degrees of avoidance’ (towards buying any stock) based on underlying sentiment. One man’s entry point is another’s cue to sell, and LPTs are a prime example. While Anton Tagliaferro investment director with Investors Mutual recommends avoiding LPTs, some fund managers believe historically low unit prices make for timely selective investments in LPTs. “We continue to avoid fancy investment bank stocks, like Allco or most other LPTs, because in our view stapling, overleveraging and financial engineering has made them an extremely risky sector,” says Tagliaferro.

Interestingly, Hollyman says good growth stocks that have become overly expensive can also become stocks to avoid due to risks of re-pricing on the downside. On the flipside, investors who are prepared to take a long-term view on beaten down stocks (take Macquarie Bank as an example), may see the current price as an attractive entry point.

Given where we are within the current cycle, Hollyman says there’s no real compulsion to be buying stocks within the retail, aviation and transport sectors right now. He says stocks wrong-footed by regulatory hurdles, notably Tabcorp, and Tatts Group (and possibly Telstra) should be avoided unless investors want to hold in hope of future M&A upside.

And as investors who bought Queensland Gas Company (QGC) recently discovered, there’s danger in buying stocks (after a significant rally) on the assumption prices will continue rising. Few expected an ACCC enquiry into BG Group’s 20% stake in QGC. After soaring from $3 to $6.20 over several weeks, QCG share price abruptly retreated to just over $4.

“With consumer confidence still at record lows, discretionary retail stocks like Just Group, Harvey Norman are going to find it tough,” says Hollyman. “We also recommend avoiding stocks with significant exposures to the US housing cycle, like Boral, those with overseas domiciled earnings, notably in USD, (like Billabong, James Hardie, News Corporation, Aristocrat, Brambles and Westfield), and anything with significant exposures to oil in its operating costs (like Virgin Blue and Qantas).”

At the individual stock level, Hollyman says outlook statements this reporting season reveal a lot about underlying earnings potential. He says what companies’ flag to the market about future trading conditions, plus their dividend intentions (as Virgin Blue discovered) can make it easy to place a ‘don’t buy’ against them. The beleaguered airline’s decision not to declare a dividend led to a mass dumping of the stock.

According to Hollyman, investors should also look to avoid stocks that are trailing their respective sector group. “Investors should be looking to stocks that can deliver a year-on-year return on earnings (ROE) of 20%,” advises Hollyman. “On stocks trading at a premium to the benchmark, investors want to see earning growth of at least 10%.”

Geoff Wilson chairman of Wilson Asset Management recommends avoiding stocks with 50%-plus debt to equity levels, especially those close to debt refinancing. He says that’s one of many reasons why he recommends zero exposure to LTPs like Centro and MFS.

Wilson says the structural shift in LPTs from their older business model as listed landlords to ‘Jack’s of many trades’ has left investors unclear of where their earnings really come from. “Avoid stocks with unsustainable business models or where you don’t understand how they make money,” warns Wilson. “Stay away from companies that rely more on the revaluation of assets than the generation of cash flow from operating activities.”