Don't Poison Your Portfolio

Most of us wouldn't knowingly ingest poison and expect a positive outcome. I mean, come on -- it's poison. That stuff'll kill you, right?

So I have to wonder why so many investors gravitate toward poisonous stocks. Cheap or not, those stocks will kill your portfolio -- and when there are plenty of good stocks to choose from, it makes even less sense.

Of course, these stocks don't come with "Mr. Yuck" stickers, or more to-the-point, skull and crossbones symbols to warn investors of their toxicity. But there are two warning signs that, especially in the current environment, you'd do well to heed.

Toxic business
If a company's business is in the toilet and seeing no immediate signs of recovery, that's a sign to stay away -- even if it looks cheap, and even if it is likely to recover one day.

Take Talbots (NYSE:TLB), which is struggling with a tough economy, a skittish consumer, and an intensely competitive industry even in good times.

Meanwhile, Talbots has a total debt-to-equity ratio of 179.8%, and in the last 12 months, it's lost $4.04 per share. The stock has plunged 69% in the last year and trades at about $2 per share -- but that isn't enough to convince me it's a bargain.

Or what about Isle of Capri Casinos (NASDAQ:ISLE)? Its stock has also fallen 67% in the last 12 months, and at about $3.94, it's still not cheap; it's got $1.48 billion in debt, and just $104.7 million in cash. The casino industry is in big trouble now that consumers are ratcheting down their spending, and a massive debt load is a serious problem when business -- and revenue -- slows considerably.

Sure, there's a chance companies like these could come back at some point. But as noted value investor Seth Klarman recently said, at some point being too early becomes indistinguishable from being wrong -- and I don't see any reason for investors to even try to take that gamble.

Toxic debt
One of the most poisonous attributes I can think of is a high level of debt -- especially given the current credit crisis. Match that with flagging profitability (or even net losses) and declining or anemic business and you may have a toxic combination on your hands.

For example, let's take a look at a few companies with high debt-to-capital ratios.

All data from Capital IQ and Yahoo! Finance as of Jan. 12, 2009.

These all look like hemlock to me. Embarq did manage a profit in the last 12 months, but its revenue has decreased, and it's currently looking to merge with another telecom company in order to address the economic downturn. Tenet Healthcare may have managed decent revenue growth, but the poor economy means that many patients are now unable to pay their bills.

Carroll's Restaurant Group may have managed to report a profit, but its annual profits have been decreasing since 2006 and it's got a mere $2.9 million in cash. None of these stocks constitute a gamble I'd personally want to take, especially given their debt loads.

After all, financing is harder to come by these days, and interest rates choke the monies that companies bring in no matter what the macroeconomic climate. With consumers feeling strapped, many companies will also see less money coming in -- and that's a recipe with a bad aftertaste.

Stocks for a healthy portfolio
There's absolutely no reason to take undue risks on such possibly toxic stocks -- especially when opportunities abound to buy strong, superior companies for the long haul. This bear market has reduced the price of any number of profitable companies with great brands and little or no debt on their balance sheets. Those are the kinds of stocks that will keep your portfolio healthy over the long term.

Tom and David Gardner have long focused on finding wholesome stock ideas for Motley Fool Stock Advisor. Recommendation Dolby Laboratories (NYSE:DLB) is an example of a company that has ample cash on the balance sheet, generates copious free cash flow, and has a miniscule amount of debt. Their recommendations overall are beating the S&P 500 on average by 29 percentage points. Why play around with poison when you can get a 30-day free trial to all of the Gardners' best bets for new money now? Just click here to get started -- there's no obligation to subscribe.

This article was first published Nov. 8, 2008. It has been updated.

Alyce Lomax does not own shares of any of the companies mentioned. Dolby Laboratories is a Motley Fool Stock Advisor recommendation. The Fool has a disclosure policy.