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Your Core Portfolio: More Special Situations (Shorts)

The Special Situations portion of Your Core Portfolio is really intended for situations that you recognize on your own as being unusual. You might have some expertise in a sector or business that gives you the “one-up on Wall Street” that Peter Lynch discussed in his seminal book.

Sometimes, you might stumble across these situations by accident. That’s what happened to me while I was hunting for some new Preferred stocks to add to my portfolio. I had set certain criteria for adding these stocks, found a comprehensive list of all Preferreds that exist in the market, and applied those criteria to generate a screened list.

Much to my surprise, I found that stocks were either worthy of purchase or were definitive short opportunities. I had expected very few shorts to appear, yet here they were in spades — not the Preferreds, mind you, but their underlying common stock.

Asset Allocation Asset Allocation
Large-Cap Growth 15% Options 5%
Large-Cap Value 15% Midcap Growth 4%
International/Emerging Market 15% Midcap Value 4%
Income-Driven 14% Small-Cap Growth 4%
Special Situations 10% Small-Cap Value 4%
Swing Trades 10%

One that leapt out at me was Goodrich Petroleum (GDP), a natural gas and oil play with almost 400 producing wells. The company’s expenses are so high that they wipe out revenue, leading to repeated operating losses. Add a quarter billion dollars in annual capex to the operating losses, and then another few million in dividends. The result is year after year of negative free cash flow, around $100 million in the TTM. That might be fine if the company had hundreds of millions in cash … but it doesn’t. It has $5 million … and $554 million in debt, which it’s paying almost 10% interest on. Bulls are relying on a relatively young shale discovery, but I don’t see how pumping oil out at a loss works in the long run.

Miller Energy Resources (MILL) also stuck out as a problematic stock. It holds leasehold interests, license rights and interests in oil and gas wells. This is another company with a history of operating losses in the low-to-mid eight figures, and $33.5 million in operating losses over the TTM. It has another $6.4 million in interest expense on its $51.5 million in debt. It has $18 million in cash and long term investments, but $45 million in capex over the TTM, along with a million bucks in dividends. Again, all I see is a cash suck.

Maryland-centered shopping mall real estate investment trust Saul Centers (BFS) trades at $44 per share, and I can’t figure out why. It has 43 shopping centers, 5 office operating properties, and 5 non-operating development properties. The lack of geographical diversification makes me nervous. The company generates operating income in the mid-$30 million range annually, but is saddled with such expensive debt that the $47.5 million in interest expense wipes out any profit. The company pays around $20 million in preferred dividends and has poured tons of capex into its properties — $59 million in the TTM after hundreds of millions in F10 and FY11, sagging free cash flow even more. And that’s on top of $50 million in common dividends. I just don’t see how any of this is sustainable.

One word of warning before you charge forward to short these stocks. I found these while hunting for other stocks, so I haven’t delved deeply into them. You should always do independent research before investing, but it’s especially important before shorting stocks. Energy companies in particular should be examined closely, because they may be sitting on huge reserves or have other mitigating factors.

But if these stocks still look to be in poor shape upon further examination, they’d make a great addition to the 10% of your portfolio dedicated to speculative plays.

As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities.

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