We often look not only for the best stocks the markets have to offer but we also look to avoid the worst stocks the markets have to offer. Theoretically, if an investor was to buy only the best 400 out of the 500 S&P 500 stocks, by excluding the worst 100 stocks, he could consistently beat the market. We believe that knowing what stocks/sectors to avoid is half the battle when it comes to getting good risk adjusted returns.
One stock, which we would avoid, is Range Resources (NYSE:RRC). Range Resources is primarily a natural gas exploration, development and production company with assets in the Marcellus Shale and Appalachian Basin of the United States. In general, we are avoiding the natural gas sector because we fear that it may take many years for the supply/demand characteristics of the industry to come into better balance thus supporting higher natural gas prices. As of late, the natural gas industry has been a poor performer due to low industrial demand and a glut of natural gas supply. We think that the situation will not change in the near future as there is still a great deal of current exploration and development activity in this sector.
The reason we believe that Range Resources is overvalued is that it has an aggressive capital spending program that is not completely supported by operating cash flow. To continue exploring and developing natural gas projects, at the present rate, Range Resources will most likely go deeper into debt. As the company becomes more highly levered, it becomes a much riskier investment. An investment that we will choose to avoid. In our opinion, if Range Resources continues to expand its natural gas operations, at the current rate, it may experience financial hardships if natural gas prices do not improve. If you are optimistic about possible higher natural gas prices then Range Resources may be a good way to play that investment thesis. However, we do not have an optimistic view for natural gas prices and we will not buy or hold shares of Range Resources at this time.
In terms of valuation, we believe that Range Resources is overvalued at $75.40/share for the following reasons:
- Range Resources has an expensive forward earnings multiple of 34.12 times 2014 projected earnings.
- Range Resources has a weak balance sheet with $2.94 billion in debt and just $194,000 in cash. Also, Range Resources has negative free cash flow, which is insufficient to service a growing debt load.
- Range Resources has an expensive PEG ratio of 2.81 and an expensive EV/EBITDA ratio of 19.23.
- Of the 36 analysts covering the stock, 19 have either a Hold or Sell rating on the stock.
- S&P has a Strong Sell rating on the stock (1 out of 5 Stars) and a 12-month price target of $65.00/share. Also, S&P estimates that the Fair Value of Range Resources shares is just $49.00/share
Disclaimer: Ulfberht Capital is not an investment advisor. This article is not a recommendation to buy or sell securities. Always consult your investment advisor before making any investment decision.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.