These Stocks Are Trash!

A few years ago, I was sledding with my wife in her hometown of Virginia Beach when I heard someone yell "Whooooooo, Mount Trashmore!" as he soared down the snowy hill. Thoroughly confused, I turned to my wife and asked, "Mount Trashmore? What the heck is that?"

A dirty trick
I soon found out that Mount Trashmore is a landfill being put to new uses. In winter, covered in snow, it just looked like a great place to go sledding. In the spring, it becomes a park crowded with residents using basketball and volleyball courts, enjoying the rolling green hills, and climbing the hiking trails that surround a beautiful lake.

But underneath it all -- it's just three miles of trash!

Why should you care?
If you think about that situation, it seems eerily similar to the stock market.

Consider this: How many times do you see a share price shoot up and think to yourself, "Wow, that must be a great company"? Then, after doing some research, you find out the business is drowning in debt and hasn't made money in years.

Look at Fannie Mae or Freddie Mac -- both companies have experienced substantial price increases over the past year. But more incredible is that they received more than $50 billion in taxpayer bailout money, both companies suffer from sloppy management, and both are expected to post huge losses for 2010.

Rising prices can make companies look good on the surface -- just like how Mount Trashmore looked good to me -- but when you take a closer look, they're simply trash.

Take a look at some of this debris:

Data from Capital IQ, a division of Standard & Poor's.

These stocks have brought astronomical gains in the past six months, but they're trading at ridiculously high valuations, they're riddled with debt, and their businesses have been unable to sustain top-line growth. Nevertheless, they're seeing spikes in their prices as if they are about to enjoy tremendous earnings growth for several years.

Some of these companies may have been smart picks once upon a time, but if you have them in your portfolio right now, I'd take your gains and toss the stocks into the incinerator as fast as you can.

Don't be fooled
In actuality, Mount Trashmore isn't such a bad thing. It employs the best possible use of urban land by combining recreation with waste management.

But stocks like the ones above don't serve a purpose anymore. They're deceptive because of their extraordinary returns, and they often push you along with a herd of other investors who are concerned only about short-term price movements.

Many growth companies like InterOil (NYSE: IOC) and iRobot (Nasdaq: IRBT) have absolutely crushed the market over the past year, reaping gains of 90% and 76%, respectively.

Now I'm no hater of either of these companies, but they sport forward price-to-earnings ratios of 146 and 51. Sure, they're both supposed to grow above a 20% clip over the next five years, but at a certain point, any prudent investor must ask himself if a stock is simply overvalued.

The same can be said for investors who have bet on shaky turnaround stories like Sirius XM Radio and Crocs (Nasdaq: CROX). In particular, Crocs has gone up by 270% in the last year -- yet not that much has changed in its fundamentals. It has a very weak economic moat, it has negative operating margins, and it's trading for 22 times next year's earnings. As an investor, you've got to start deciding whether your investments make sense over the long haul.

Instead of following the pack or keeping stocks in your portfolio that clearly don't belong, why not try a simpler, more levelheaded approach? Look for companies that have clean balance sheets and limited debt, that have strong positions in their competitive landscape, and that are trading at favorable valuations -- companies like Activision Blizzard (Nasdaq: ATVI).

Here's one thing Activison Blizzard has that we look for at The Motley Fool: a wide economic moat. The company is the leading video game publisher in the world and has a strong pipeline of franchise games such as Tony Hawk, Call of Duty, and Guitar Hero. It not only brings in big bucks for its games that play on PCs, Sony's Playstation, Microsoft's Xbox, and Nintendo's Wii, but it also benefits from incremental revenues from things like guitar-shaped controllers and song downloads. Last year, it generated over $1 billion in free cash flow.

In addition, its balance sheet is clean as a whistle. It has over $3 billion in cash and zero debt, putting it in a great position should another acquisition present itself. And did I mention that it's trading for a measly 14 times forward earnings? Conclusion: Activision Blizzard has all the traits of a great stock, from top to bottom.

If you're having a difficult time separating the trash stocks from the good ones, our Motley Fool Stock Advisor newsletter is a great place to start. David and Tom Gardner offer two stocks every month they'd be happy to own for years, and there are 10 stocks they think you should buy right now. If you're interested, click here for a free 30-day trial. There's no obligation to subscribe.

This article was originally published Oct. 8, 2009. It has been updated.

Fool contributor Jordan DiPietro owns shares of Activision Blizzard. Microsoft is a Motley Fool Inside Value pick. iRobot is a Motley Fool Rule Breakers recommendation. Activision Blizzard and Nintendo are Motley Fool Stock Advisor choices. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. Motley Fool Options has recommended a diagonal call position on Microsoft. The Fool owns shares of Activision Blizzard. The Fool has a disclosure policy.