Editor's note: This article originally listed Generex Biotechnology as having received a “going concern” warning. Generex is a development-stage biotech that raises money in the public markets and uses the money to fund its R&D; in this case, the warning does not necessarily reflect poor financial condition.
It's undoubtedly been difficult for many individual investors to avoid the temptation to snap up shares of well-known companies now trading in the penny stock range. If you're one of them, I implore you: Don't give in without doing your homework. Most of those beaten-down stocks are in the dumps for good reason.
Despite a few signs of improvement, the macroeconomic climate has been brutal. Many consumers had too much debt. So did many companies. As a result, many companies will be blown right out of the water by the resulting massive deleveraging.
And now that consumers are dealing with plunging asset values, untenable debt, and increasing job losses, many companies' sales are understandably pinched, making it more difficult for them to service their own debt or borrow more to fund their operations. All of which makes for one seriously ugly domino effect.
Going, going, gone?
Last year, many people made wild bets on financial stocks like Fannie Mae, Freddie Mac, and Merrill Lynch. I'd guess that many of these folks unwisely ignored those companies' balance sheets, which are more important than ever in these troubled times. Indeed, these investors are still making wild bets; AIG (NYSE: AIG) has been a very popular stock for speculators, despite its high-profile troubles and reliance on government support.
The folly of shoddy due diligence has become evident in the increasing numbers of companies disclosing "going concern" warnings from their auditors. You can find those warnings in a company's quarterly (10-Q) or annual (10-K or 20-F) filings with the Securities and Exchange Commission. Usually, there will be a paragraph with language about factors that "raise substantial doubt as to our ability to continue as a going concern."
Need a well-publicized recent example of such a company? Look no further than CIT Group.
Cause for concern
When companies find it increasingly difficult to make ends meet, have negative cash flow, or can't find anybody to lend them money, auditors often eventually question their abilities to stay upright and in one piece. As you can imagine, such questions are popping up a lot more often these days.
Long-struggling Select Comfort (Nasdaq: SCSS) received such a warning related to its 2008 financials earlier this year, although it has since seen better days (and a big buy-in from a private equity firm). Escalon Medical and Allied Capital (NYSE: ALD) have both disclosed their own auditor warnings in recent memory.
Even though companies can and do take actions to fix these problems, such as amending credit agreements -- or, in Allied's case, being bought out by Ares Capital (Nasdaq: ARCC) -- the warning remains a dire sign that investors should take very seriously.
Accountants are usually reluctant to raise such red flags. According to a recent survey, only about half of companies that filed for bankruptcy in 2001 had actually received "going concern" warnings, and some companies that didn't actually ended up bankrupt anyway. A recent study by Duff & Phelps brought up that problem, noting that rapidly changing factors can make a company's ultimate fate hard to prognosticate.
Still, the proliferation of these warnings, and the reasons why companies fail -- obvious flaws such as lack of profitability and too much debt -- should lead investors to think twice about the beleaguered, supposedly "cheap" stocks they're choosing for their portfolios. There could be more spectacular flameouts on the way. Both the U.S economy and the average consumer are in bad shape, and many struggling, overindebted companies simply won't be able to survive.
Go for the gold, not for the goners
But plenty of stocks do represent strong companies with worthy management and little or no debt -- the kind of companies positioned to survive macroeconomic hardship while beleaguered rivals get taken out.
The team at Motley Fool Stock Advisor, which is beating the S&P by 42 percentage points on average, seeks only the highest-quality companies. Consider newsletter recommendation Berkshire Hathaway (NYSE: BRK-A) (NYSE: BRK-B). Prudent leadership by legendary investor and business mind Warren Buffett represents the gold standard in solid, well-led companies that are built to withstand the test of time.
However tempting the smorgasbord of beaten-down stocks may appear, let's all try to avoid too much speculative bravado. Go for the gold, not the goners. If you're looking for more stock ideas, you can click here to read more about the Stock Advisor team's favorite picks, free for the next 30 days.
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This article was originally published on May 12, 2009. It has been updated.
Alyce Lomax
does not own shares of any of the companies mentioned. Berkshire Hathaway is a Motley Fool Stock Advisor and an Inside Value pick. The Fool owns shares of Berkshire Hathaway and has a disclosure policy.
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