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Why I’d shun this almost 5%-yielding ‘superstock’ and what I’d buy instead

I think DFS Furniture (LSE:DFS) is one of the most dangerous shares around for long-term investors right now.

Yet on one popular share research website, the stock has earned the label ‘superstock’ because of its tasty-looking indicators for value, growth and momentum. And I must admit, at first glance, DFS does look attractive with its price-to-earnings rating running just over 11 and the dividend yield at about 4.8%.

Trading well, but…

City analysts have pencilled in some chunky double-digit percentage increases in earnings for this year and next too, which adds to the superficial appeal of the share. But dig a bit deeper and the company starts to reveal weaknesses. For example, the record on earnings is patchy, the shares have moved up and down in big swings over the past few years, and net debt looks high.

Indeed, DFS’s business retailing living-room furniture is one of the most cyclical a company can participate in. Things look like they’re swinging along nicely now, but given a ‘half-decent’ general economic downturn, everything could come crashing down – profits, dividends, the share price. Everything could hit the floor together and leave the company struggling to pay the interest on its debt. That’s the big risk you take by owning shares in a cyclical firm such as DFS.

However, despite the risks, I would consider owning DFS shares short-term to catch a cyclical up-leg. But I’d keep one finger on the ejector button ready to press at the first sign of trouble. Meanwhile, today’s half-year results look trouble-free. Revenue rose just over 29% and by almost 10% on a pro-forma basis that adjusts for the full inclusion of the firm’s recent acquisition of a company called Sofology. Underlying pro-forma earnings per share shot up an impressive 90%.

There may be trouble ahead

But in another clue to the fragility of the sector, the directors held the interim dividend at last year’s level. That seems sensible to me because if a cyclical business doesn’t use its incoming cash flow to pay down its debt in the good times it could be in trouble with its borrowings in the bad times. So, it’s no good the firm giving away too much cash to shareholders now.

Chief executive Tim Stacey said in the report he expects the market “to remain particularly challenging in 2019,”  which is a red flag for me. However, he thinks the firm’s investments in online channels, delivery networks and brands will “help mitigate” the current economic and political uncertainty. I admire his optimism, but wouldn’t bet on those things helping much if the economy turns down from here.

Rather than a cyclical outfit such as DFS, I’d rather place my long-term investments in shares backed by firms with more defensive operations such as National Grid, Unilever, Britvic,and many others. Another decent way of ironing out some of the cyclical risks is to spread your investment across many underlying companies. A neat way to do that is to invest in a low-cost index tracker fund, such as one that follows the FTSE100 or FTSE 250 indices.

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Kevin Godbold has no position in any share mentioned. The Motley Fool UK owns shares of and has recommended Britvic and Unilever. Views expressed on the companies mentioned in this article are those of the writer and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool we believe that considering a diverse range of insights makes us better investors.