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The 8 FTSE 100 shares to avoid

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The 8 FTSE 100 shares to avoid

The FTSE 100 (UKX) is up just under 4% in 2017 so far, not bad. It would have been more, however, but for a series of profit warnings from seasoned blue-chips like BT (BT.A) and Provident Financial (PFG). And headwinds remain, among them rising costs, regulatory change, a questionable consumer outlook and, of course, Brexit.

We've seen recently how companies right through the food chain are vulnerable, although perhaps the carnage at Carillion (CLLN) was one of the more predictable disasters.

Unfortunately, it's not always that easy to spot where the next profits warning is coming from. However, analysts at broker Liberum have come up with a pretty comprehensive checklist that might help. And it's got a great track record.

In each of the three years Liberum has run the numbers, the portfolio of dogs has underperformed the market.

Last year, of the seven FTSE 100 stocks it said avoid, Pearson (PSON), Capita (CPI) and Next (NXT) all issued ugly profit warnings. It's why the 2016 'sinners' underperformed the blue-chip index by 16%, or 24% if you strip out the takeover of ARM Holdings.

Now in its fourth incarnation, the team at Liberum has once again trawled FTSE 100 annual reports, analysing the 14 areas* it believes may indicate business risk - an auditor's assessment, 12 quant screens and an evaluation of remuneration policies.

After putting the top 100 companies through the mincer, the broker has named the eight which have triggered five or more 'red flags'.

There are some familiar faces - Pearson and Next from the Class of 2016 appear again - and six new entrants, including worst of all the FTSE 100 stocks using this screen - Babcock (BAB), Vodafone (VOD) and G4S (GFS).

The 8

Best to get the oddball out of the way first.

It's the screening tool, not Liberum that's saying avoid Babcock; the broker recently repeated its 'buy' rating and £11 price target, implying 30% potential upside.

"Auditors highlight a significant degree of judgement in revenue recognition, while Babcock has been a consistent exceptionals user and has seen increased receivable and payable days," according to the 'red flag' system. "Babcock also screens as ageing assets flattering free cashflow (FCF), number of independent board members (governance) and size of CEO compensation."

However, Liberum's support services analyst Joe Brent says exceptionals are largely a function of Babcock's history of acquisitions, and he expects acquisitions to be a smaller part of the strategy going forward given the lack of impactful targets.

True, receivables and payables have increased, but improvements in net debt, pensions and leases have soothed concerns around the balance sheet.

Elsewhere, Vodafone triggers six flags, with auditors highlighting risk in the accuracy of revenue recognition. Voda screens for consistent exceptionals use, rising receivables and payables, falling deferred revenue and stretched cash dividend cover," writes Liberum.

It's had a stunning 12 months, but security company G4S raises five flags. "Auditors cite risk in onerous, long-term contracts with subjective treatment of specific income statement items," says Liberum. "G4S also screens for exceptional use, doubtful debtors, 'missing' capex and compensation."

The remaining five stocks also generate five flags, among them high street retailer Next. This time it screens for increased receivables days and inventory, IFRS 16 (the new leases standard), governance and in the earnings manipulation model.

At Berkshire-based software firm Micro Focus there are concerns around stretched cash dividend cover, flattered FCF, the earnings manipulation model, governance and compensation.

Supermarket chain WM Morrison (MRW) auditors flag commercial income judgements, onerous lease provision and inventory as areas of risk. It also screens for payable days, 'missing' assets, IFRS 16 B/S adjustments and remuneration.

Drugs giant Shire (SHP) screens within "consistent exceptional use, doubtful debtors, 'missing' capex, the earnings manipulation model and governance". Liberum analysts are also "cautious on the M&A based model's (a reason for missing capex) ability to plug the hole in earnings left from patent expiry and competition".

And lastly, Pearson. In the sinner's list for a third consecutive year, the share price has dived around 60% since early 2015 following a string of profit warnings and sale of the Financial Times.

In fact, Pearson is the only one of these stocks that Liberum "would actively recommend shorting" as it aligns with the house view.

"Auditors continue to flag the risk of material deferred revenue and major restructuring," writes the broker. "Pearson also screens in cash dividend cover, 'missing' capex, the financial distress model and IFRS 16 B/S adjustments."

*The 14 red flags are:

1. Auditor Reports: Risks of Material Misstatement

2. Exceptionals: Consistently adjusting earnings

3. Doubtful Debtors: Screening for material changes

4. Revenue Recognition: Receivables

5. Revenue Recognition: Long-Term Receivables and Contract Accounting

6. Revenue Recognition: Deferred Revenue

7. Working Capital: Inventory

8. Working Capital: Payables

9. Debt for Dividends: Cash Dividend Cover

10. Capex: FCF Flattery/Ageing Asset Portfolio

11. Bankruptcy and Manipulation Models

12. Operating Leases: Accounting Policy Changes

13. Governance: Board Independence

14. CEO Remuneration: Performance and Size

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise.The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.