A Value Stock to Avoid in This Market

Make no mistake about it -- this is a very scary market. Yesterday, the CBOE Volatility Index (aka the "investor fear gauge") hit 80 once again, indicating nothing short of a full-fledged market panic.

Two months back, I advocated the importance of keeping a long-term focus and strategically avoiding the media blitz of bad news. But keeping your cool in this mess doesn't apply only to panic selling, but also to panic buying.

Just because a number of stocks like Rite Aid have fallen considerably in recent weeks doesn't mean they've reached the point of maximum pessimism and are worthy of buying whole-hog right now. In fact, I would argue that Rite Aid is one "value" to avoid in this market.

You don't own me
For one, Rite Aid is heavily reliant on debt to fuel its respective operations. As of the end of 2007, Rite Aid was capitalized with 78% debt. Simply put, debtholders, not common stockholders, all but run the show at the company. Those debtholders care most about getting their money back, plus interest; they don't necessarily have any interest in long-term earnings growth.

Additionally, with all that's happened in the credit markets this year, companies like Rite Aid will find their continuous need for debt increasingly costly. When a company has to boost interest rates on its debt to attract investors, its interest expenses increase, leaving less left over for earnings.

This brief analysis doesn't even consider Rite Aid's intense competitive landscape. Rite Aid competes with the larger, more efficiently run CVS Caremark and Walgreen pharmacies, and even large discounters like Target (NYSE: TGT) and Wal-Mart (NYSE: WMT) making margin growth, market-share expansion, and overall recovery even more difficult.

While there's always a remote chance that Rite Aid will miraculously turn itself around, I wouldn't bet hard-earned money on it. There's simply easier money to be made in the market.

Like how?
When the market is scared and the debt markets are unpredictable, it pays to start your search by looking for superior companies whose stocks may have been unfairly punished. In short, this means seeking out stocks:

• Trading more than 50% off their 52-week high,
• With little or no long-term debt reliance,
• Return on equity above 15%
• Positive free cash flow, and
• Cash in the bank.

Here are some examples:

Company	% Below 52-Week High	Return on Equity
IntercontinentalExchange (NYSE: ICE)	(74%)	19%
Cummins (NYSE: CMI)	(77%)	25.7%
Baker Hughes (NYSE: BHI)	(70%)	24.9%
Amazon.com (Nasdaq: AMZN)	(64%)	38.1%
Adobe Systems (Nasdaq: ADBE)	(55%)	18.6%

Source: Capital IQ, a division of Standard and Poor's.

Like Rite Aid, these companies have been beaten down in this market, but their futures are much brighter. Since these companies generate enough cash by themselves, they don't need to reach out to the debt markets to maintain operations, and they can remain focused on shareholder interests.

Buy them now?
Even though you now know which values to avoid and which ones to consider in this market, that doesn't mean you should invest all your savings right now. While the market seems very pessimistic right now, it may not be the point of maximum pessimism. Nevertheless, now is a great time to begin (or keep) adding money to great companies trading at great prices.

The last time the market was this scared of equities, as measured by the CBOE Volatility Index, was August through October 2002. During this period, Fool co-founders David and Tom Gardner picked six stocks for Motley Fool Stock Advisor subscribers that have since returned an average of 56%, versus -18% for the S&P 500.

Cautiously investing in this market is understandable and smart, but the most important thing is to keep adding money to your portfolio. Rather than chasing value traps like Rite Aid, focus on companies with strong business models that will serve them well when the market finally comes around.

These are the types of stocks we look for at Stock Advisor. If you'd like to learn more, consider a free 30-day trial to the service on us.

Todd Wenning likes his sugar with coffee and cream. He does not own shares of any company mentioned. Wal-Mart Stores is a Motley Fool Inside Value recommendation. Amazon.com is a Stock Advisor selection. The Fool's disclosure policy fights for its right to party.