Stocks to Bet the House On

"Mortgage the house on this one, folks."

That was a post on the Yahoo! message boards from Aug. 10, 2006. The stock referenced had dropped nearly 50% since the beginning of the year, yet it had more than tripled its revenue year over year, and it seemed on the verge of dominating its only competitor.

An apparently enticing situation, we agree. And our poster was ready to go whole hog.

Bait ... and switch!
The truth is plain and simple: There are no stocks worth betting the house on. If anyone tells you otherwise, run in the opposite direction. That's because even "seemingly enticing situations" can turn out to be not-so-enticing after all. The stock in question with our Yahoo! poster was Sirius Satellite Radio, and along with that growing revenue, it had massive debt obligations, more than $1 billion in losses over the past year, and a troubling addiction to shareholder dilution.

So what has Sirius done since Aug. 10, 2006? It's dropped 15%. In other words, we're hoping our poster was speaking in hyperbole, and isn't currently servicing the debt he took on to buy Sirius shares.

You guys are too much
We're not speaking in hyperbole here. More Americans are playing the market without realizing that they're assuming risks that can decimate their brokerage accounts, their savings accounts, and, yes, even their homes. According to a recent New York Times article by Floyd Norris, "American investors are now deeper in debt -- at least in their margin accounts -- than ever before." The total of margin debt for U.S. accountholders climbed to more than $322 million by the end of 2007.

We view this with mixed emotions. For one, market exuberance doesn't seem to be at play, as it was at the turn of the century when folks were leveraged up to their ears to buy stocks with price-to-earnings (P/E) ratios of 250.

But if the market survives its recent volatility and continues to trend upward, average investors will become even more daring. And that's when those daring investors will take advantage of the rest of the money available to them.

Margin madness
You can see the disaster lying in wait here. By the time your average investor feels confident enough to get margined to the hilt, it'll be too late.

And that's when these same investors will use margin to start buying stocks with triple-digit P/E ratios, or worse, triple-digit price-to-sales ratios.

Seriously, it happened
Recently, we happened upon a painful post on our Motley Fool message boards written by a gentleman who maxed out his margin account in 2000 to buy shares of Celera as it was falling.

Like our Sirius poster, he had the right idea. He wanted to make a big bet on a stock he thought was being treated unfairly by the market.

Unfortunately, Celera also shared another trait with Sirius: It was losing more than $100 million each year.

That did not stop investors from buying big into Celera's plans to map the human genome. Optimism for the company was so great that at its peak, shares sold for 263 times sales.

That's right: 263 times sales. For context, EMC (NYSE: EMC  ) sells at 2.6 times sales, while Kraft Foods (NYSE: KFT  ) sells for 1.3 times sales. Heck, "expensive" growth stocks such as McAfee (NYSE: MFE  )  and Motley Fool Stock Advisor recommendation DreamWorks Animation (NYSE: DWA  )  sell for just 4.3 and 3.6 times sales, respectively.

We probably don't need to tell you how it ended for our poster, or for anyone else who went whole hog on Celera in 2000. The company's stock chart tells the whole story.

You're better than that
While the Celera tale may be extreme, it's certainly not the only anecdote of its kind. That's why we advise you to strictly adhere to an investing philosophy that suits your goals, risk tolerance, and time frame -- even if you've happened across a so-called stock to bet the house on. Because big margin bets over the past year on seemingly better-priced stocks such as MGIC Investment (NYSE: MTG  ) , Pulte Homes (NYSE: PHM  ) , and IndyMac (NYSE: IMB  ) also could have gone horribly, horribly wrong.

For example, here's what Fool co-founders and Stock Advisor analysts David and Tom Gardner recommend for any investor who is less than an expert:

  1. Broadly diversify.
  2. Invest new money on a regular basis.
  3. Eliminate emotion from your decision-making.
  4. Expect mistakes.
  5. Scale back any individual position, or your overall exposure to stocks, if you're fretting about the volatility.

Supercharge your returns
The easiest way to crush the market over the next few decades is to be the patient long-term owner of great companies. And if you can do that and be disciplined in your stock picking, you'll never have to bet the house in order to help you buy a house ... or two.

But if you decide margin has a place in your portfolio, we're not here to tell you that you're wrong. Margin can enhance your returns. But if you use too much and don't know what you're doing, it can wipe out your life savings. That's why we recommend that:

  • Unless you are 100% comfortable and have read (at least twice) the margin agreement with your broker, stay away altogether. It's just not worth the hassle.
  • If you decide to use margin, keep it at 20% or less of your total portfolio's worth.
  • You should never use leverage in a way in which the resulting worst-case scenario would cause you financial ruin. Never.

Of course, if you ask us, patient long-term investors in great companies don't need margin. After all, that's the tack we take at Stock Advisor, where our picks are ahead of the market by more than 41 percentage points on average. You can see all those picks, as well as our top five for new money, with a no-obligation 30-day free trial. Click here for more information.

This article was first published on March 20, 2007. It has been updated.

Tim Hanson and Brian Richards heartily recommend chocolate chunk cookies as a midafternoon snack. They do not own shares of any company mentioned. Kraft is an Income Investor recommendation. The Fool's disclosure policy, while satisfying, is not quite as satisfying as a midafternoon chocolate chunk cookie.


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