The Worst Stocks to Buy Today

If you missed the best week to buy stocks, you might be kicking yourself. I know I am. The market is, after all, up more than 60% from its March 9 low.

But just as it was unwise to panic-sell when everyone around us was losing their heads, it's equally unwise to panic-buy now that the market is in rally mode.

The sudden switch in investor sentiment -- from stocking up on gold, potatoes, and ammunition in early March to "everything's going to be OK" just months later -- is reason enough to be skeptical of this rally.

The key to investing success, as always, is being patient and continuing to buy quality companies trading at good values. This rally, however, has largely been led by inferior companies that had been heavily shorted and left on death's doorstep.

Trying to hitch a ride on them now may be tempting, but proceed with caution.

Garbage-pail kids
Following a string of notable bankruptcies, from retailers like Circuit City to once-vaunted financial institutions like Lehman Brothers, investors rightly began to wonder who would be the next to fall.

Indeed, the futures of a number of well-known American institutions were in considerable doubt. Companies like AMR (NYSE: AMR  ) (the parent company of American Airlines) and Motorola (NYSE: MOT  ) , for example, were at one point in March trading at $2.40 and $2.98, respectively.

Both companies have naturally been under tremendous pressure to improve their financial statements, and both companies have cut jobs. Motorola suspended its dividend, and AMR sold some of its assets to boost liquidity.

Since March 9, AMR’s shares have gained 120% and Motorola’s 180%. These are just two examples of the recent "dash to trash" in this market rally.

Consider the profile of the 658 U.S.-based companies with current market caps of more than $500 million whose shares have gained more than 100% since March 9:

 

Debt-to-Equity

Net Income (LTM)

Return on Capital

Median

66.7%

$10 million

4.7%

Source: Capital IQ, as of Nov. 15.

Put simply, this rally has been largely led by weak hands. While it may be tempting to jump on this bandwagon now, these are the worst stocks to buy today, especially because we're not completely out of the economic woods just yet. If things take a turn for the worse again, chasing these stocks could be a very costly mistake.

Instead, investors (as opposed to speculators) should focus on profitable companies that generate free cash flow, that have a track record of rewarding shareholders with efficient use of capital, and that have strong balance sheets.

These are the types of companies that will emerge from macroeconomic turmoil even stronger than before.

Names, please
Despite the recent rally, there are still many quality companies trading at reasonable valuations that are worth further research, including the following.

Company

Price to Free Cash Flow

Return on Equity

Western Digital (NYSE: WDC  )

9.6

17.1%

GameStop (NYSE: GME  )

12.2

16.8%

Gilead Sciences (Nasdaq: GILD  )

16.8

49.4%

Starbucks (Nasdaq: SBUX  )

17.2

14.1%

Ensco International (NYSE: ESV  )

12.7

18.8%

Source: Capital IQ.

Given their size, you shouldn't expect any of these companies to become an eight-bagger in a matter of months the way Ruby Tuesday has, but you can sleep a little better at night knowing that your management team isn't slashing dividends or selling assets just to pay the bills.

Foolish bottom line
After sustaining significant losses over the past year, it may be tempting to chase after struggling companies that have had huge run-ups in this rally, but do your best to not lead yourself into that temptation. If buying distressed stocks was a gamble in early March, it's an even bigger gamble now that many have soared in price. Another downturn in the market and they could be going from heroes back to zeroes.

The market's still a volatile place, so remember to stay patient and focused on buying the companies that actually turn a profit, have strong balance sheets, and are led by top-notch management. Begin by building a watch list of stocks that you'd love to own if they fall another 10% to 20%. This way, you're ready to strike when the market gives you the opportunity.

Want to get started? You could do worse than to start your research with Netflix, one of Fool co-founder Tom Gardner's recommended core holdings for Motley Fool Stock Advisor. It's a consistent free cash flow generator and is led by one of the country's top CEOs in Reed Hastings, who is also the founder of the company.

If you'd like to learn about the other stocks we're recommending at Stock Advisor, a free 30-day trial of the service is yours. Just click here to get started.

Already a Stock Advisor subscriber? Log in at the top of this page.

This article was first published on July 7, 2009. It has been updated.

Fool analyst Todd Wenning hopes you're having a pleasant day. He does not own shares of any company mentioned. GameStop, Netflix, and Starbucks are Motley Fool Stock Advisor recommendations. The Fool owns shares of Starbucks. The Fool's disclosure policy takes out the trash.


Read/Post Comments (3) | Recommend This Article (7)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On November 16, 2009, at 4:39 PM, lilyliu008 wrote:

    your paper is the worst trash i ever saw on this board.

    you can buy IBM, APPL, GOOG, etc etc etc... they are healthy.

    CRISIS GIVES YOU ONCE IN A LIFE CHANCE TO BUY CHEAPS.

    IF YOU EXPECT AMR TO FILE BANKRUPTCY, YOU SUGGEST YOU SHORT IT TO DEATH. JUST KEEP SHORTING.

    I MADE A LOT OF MONEY FROM PLAY AMR FROM 3 TO 8.5 AND THEN BACK IN AT 5.24 AND HOLD TILL NOW. I WON'T SELL MY PIECES UNTIL THE END OF 2011 SAY, 15 BUCKS PER SHARE.

  • Report this Comment On November 16, 2009, at 4:42 PM, lilyliu008 wrote:

    This article was first published on July 7, 2009. It has been updated.

    YOU CAN SEE HOW USELESS THIS PAPER IS AND HOW POOR EDUCATED STUFF INSIDE.

    IF YOU SOLD YOUR AMR IN JULY, YOU SHOULD KICKED YOURSELF IN SEPTEMBER.

    THESE KINDS OF PAPERS ARE FROM PROFESSIONAL PAID BASHERS.

  • Report this Comment On December 02, 2009, at 10:40 PM, Hotpicks101 wrote:

    I see your point lily but I don't think you're really getting their point. If this article was published in July and they really did recommend those 5 stocks to do a little homework on, then you can easily look up how they have fared as of July. For example WDC, ESV, and SBUX are all up huge since then yet they are much less riskier stocks then both AMR and MOT from a pure valuation point of view. The other 2 gamestop and gilead aren't up but they're not down either so I don't really think this article was all that bad.

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