Stock Advice That Could Cost You Big

"Buy what you know." The popular investing proverb is snappy, sounds great, and makes investing seem simple. Unfortunately, for investors who aren't careful, it can also be costly advice to follow.

Let me tell you a little about what I know. Some folks like to collect fancy bottles of wine, others like jewelry or cars. Me? I like T-shirts. I've got drawers full of them -- ones with funny one-liners, others with throwback logos, and some that have nothing on them but are just darn comfortable.

What many T-shirt lovers like me know is that American Apparel (AMEX: APP  ) makes some of the most comfortable T-shirts you can buy. Sure they're more expensive, but to me it's well worth the price. And thus, my T-shirt stacks are replete with screen-printed American Apparel shirts.

So since I'm such a fan of the company's products, I must have been itching to buy the stock when it became a publicly traded company five years ago, right? Not so much.

The economics of American Apparel's business were never particularly impressive. Here's a look at the company's operating margin over the past six years:

 

2005

2006

2007

2008

2009

2010

Operating Margin

5.7%

3.7%

8.1%

6.7%

5.0%

NM

Source: Capital IQ, a Standard & Poor's company.
NM = Not meaningful. American Apparel reported an operating loss for 2010.

By way of comparison, check out the operating margins for some comparable companies.

Company

Trailing 12-Months Operating Margin

5-Year Average
Operating Margin

Gildan Activewear

14.8%

14.8%

Hanesbrands (NYSE: HBI  )

9.3%

9.2%

Gap (NYSE: GPS  )

13.5%

10.7%

Abercrombie & Fitch (NYSE: ANF  )

8.1%

13.6%

Source: Capital IQ, a Standard & Poor's company.

And given investors' general distaste for both Gap and Abercrombie in recent times, it's hard to claim that I'm cherry-picking comparables here.

American Apparel's cash flow statement looks a lot worse than its income statement. Over the past five years, the company's free cash flow has been in the red to the tune of $108 million. The company has also holds a pretty sizable debt load -- currently, $148 million against just $75 million in shareholders' equity. And it's that debt that forced the company to warn in its most recent annual report that bankruptcy is a possibility.

And don't get me started on the company's CEO, Dov Charney. "Loose cannon" would be a very kind way for me to describe Charney, and I'm sure that the multiple women who have filed sexual harassment suits against him might have some stronger words. In short, Charney is not the kind of steward I would trust with my money (or really anything else of mine).

I can comfortably say that I'm very happy that I never let my love of soft T-shirts lure me into American Apparel stock. The stock traded above $15 in late 2007 before going into a nasty tailspin, leaving it at the $0.82 it sells for today.

No fluke
In terms of companies that the average investor might "know" through products or services that they use, a spectacular collapse isn't a once-in-a-blue-moon happening. Here are just a select few of the companies that most of us "know" that have slumped into bankruptcy protection over the past decade.

Company

Business

Bankruptcy Date

General Motors
(NYSE: GM  )
Auto manufacturer 6/1/2009
Washington Mutual Bank 9/26/2008
Circuit City Electronics retailer 11/10/2008
Blockbuster Video rental chain 9/23/2010
Borders Group Book retailer 2/16/2011

Source: Capital IQ, a Standard & Poor's company.

Buy what you know, you say? Well what if you only buy GM cars? Or have your bank account with WaMu? Or what if -- like me -- you stubbornly held out on switching to Netflix and used Blockbuster's through-the-mail rental service? Being familiar with the business as a customer would've done a fat lot of good as you watched your stock fall to zero.

Buy what you know plus
That's not to say that investing in companies that you're familiar with is a bad thing. In fact, trying to invest in companies that you aren't familiar with and don't understand is a downright bad idea.

But finding publicly traded companies that you "know" is just the starting point. From there, you need to dig into the company's financials to figure out whether the company creates attractive returns for its shareholders. You'll want to be sure that the company is on sound financial footing and doesn't have a threatening debt load. It's also good to make sure that the folks running the company are more of an asset than a risk. And you'll want to figure out whether the price you have to pay for the company makes sense.

There are plenty of companies that fit the bill here. Visa (NYSE: V  ) , for example, is a company most of us are very familiar with (my only credit card is a Visa). It's a phenomenally efficient company with a Buffett ratio of 114%, it has very little debt, and the stock currently trades at 15 times expected forward earnings. CVS Caremark (NYSE: CVS  ) is familiar to people all over the country that frequent the company's stores for drug prescriptions and grocery items. The company has a relatively low debt load, a Buffett ratio of 31%, and its stock is even cheaper than Visa with a forward earnings multiple of 12.6.

So what do you do? Take the companies that you "know" and add them to your watchlist. You can add any of the companies above to that list by clicking the "+" sign or you can start up a new list and add whatever companies you like. The watchlist will keep these companies on your radar and help you find the news and information that you need to make a more informed investment decision.

General Motors and Visa are Motley Fool Inside Value recommendations. Netflix is a Motley Fool Stock Advisor pick. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.

Fool contributor Matt Koppenheffer does not have a financial interest in any of the companies mentioned. You can check out what Matt is keeping an eye on by visiting his CAPS portfolio, or you can follow Matt on Twitter @KoppTheFool or on his RSS feed. The Fool's disclosure policy prefers dividends over a sharp stick in the eye.


Read/Post Comments (16) | Recommend This Article (56)

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 April 06, 2011, at 5:39 PM, mikecart1 wrote:

    Actually Old Navy makes the best t-shirts you can buy. They offer the widest range of sizes from regular to tall to big to fitted.

  • Report this Comment On April 06, 2011, at 6:03 PM, TMFKopp wrote:

    @mikecart1

    Been a while since I've been in an Old Navy - I'll have to make a stop over there.

    Besides American Apparel, I'm pretty partial to Target's t-shirt selection. Most of the shirts are pretty darn comfortable and they do a good job turning over the selection so it's not always the same prints (after all, you don't want to be wearing the same shirt as everyone else...)

    Matt

  • Report this Comment On April 06, 2011, at 7:45 PM, peters46 wrote:

    The only thing wrong with the advice is that someone might take it literally and not see any reason to do due diligence. Otherwise, I take it to mean knowing the business itself, and the company's financials. When I started investing I used that rule together with 'local companies'. Local added the advantage of hearing talk/rumors from local employees/customers that people elsewhere would not hear. (This was BI - Before Internet). I added other rules such as No penny stocks, learned and paid for thru experience. Checking out the financials was always a rule for me. But every rule has qualifications (even sometimes exceptions).

    Please answer this question - why do some people pay in order to advertise a product? E.g., why do some people pay to wear shirts that advertise Coke or Apple or running shoes?

  • Report this Comment On April 06, 2011, at 8:22 PM, Striper27 wrote:

    When all the kids showing up for my summer fishing camp were wearing Crocs ... I bought in blindly. Things went quite well. Fortunately I ended up selling because a Rule Breaker (Baidu) was more appealing. The timing couldn't have been better. I hate to say ... but there was no skill involved. All luck ... but I'll take it :)

    Now I'm in a pickle because I also own a yoga studio that sells Lululemon. We do very well with it, and it does have a fanatical following, but I'm afraid the stock will follow the same "fad" cycle and I'm afraid to buy in.

    Any words of wisdom ?

  • Report this Comment On April 06, 2011, at 10:14 PM, Driver49 wrote:

    Actually, the best T-shirt for quality and comfort are the "long tail" pocket tees offered through Duluth. It's a work clothing company mail order and have also pretty much gone to a "free shipping " order limit type of company. Trust me on this one look them up and call for a catalog.

  • Report this Comment On April 07, 2011, at 1:02 AM, cordwood wrote:

    BEST T Shirts?

    IMO the GI T shirt was the best for a period in my life....soooo,I "invested" ,as Willy Clinton said, w/ my life ,if you will.

    .

    Darndest thing is I'm still "investing" in those GI Ts,and will be again on April 18...ain't no one willing to buy my "investment"...Ha!...Semper Fi !

    Costco,[Kirkland],sells a comfortable T :heavy mtl.,long tails,good price

  • Report this Comment On April 07, 2011, at 9:21 AM, cmcdesq wrote:

    Well that was informative, but now I am confused. I bought Sam Adams on your advice since beer is what I know :)

  • Report this Comment On April 07, 2011, at 9:29 AM, barrycahn wrote:

    Why do the large majority of Fool articles push the "watch list" on the readers?

    Gap has great, soft and comfortable t-shirts

  • Report this Comment On April 07, 2011, at 2:04 PM, TMFKopp wrote:

    @barrycahn

    "Why do the large majority of Fool articles push the "watch list" on the readers?"

    Why not? It's free, it's useful, and it's an easy way to grab an idea from an article... "Oh, that stock sounds interesting, let me add it to my watchlist so I can dig in further."

    Of course, I'm not sure that I'd say I'm "pushing" it on you. If you don't want to use it, feel free to skip the last 74 words of the article.

    Matt

  • Report this Comment On April 07, 2011, at 2:05 PM, TMFKopp wrote:

    @cmcdesg

    "Well that was informative, but now I am confused. I bought Sam Adams on your advice since beer is what I know :)"

    As I noted, starting your research by finding companies that you know (and beer is a good one!) is great. You just have to be sure to not stop at "I love Sam Adams beer."

    Matt

  • Report this Comment On April 07, 2011, at 2:13 PM, TMFKopp wrote:

    @Striper27

    "Now I'm in a pickle because I also own a yoga studio that sells Lululemon. We do very well with it, and it does have a fanatical following, but I'm afraid the stock will follow the same "fad" cycle and I'm afraid to buy in."

    I can't say that I have much wisdom to share on LULU. The stock frightens me thanks to its valuation -- though that's often the case with fast-growth companies. And I wasn't any more sold on the company the few times I went into the stores (you want how much for that???).

    I do, however, think that as far as fads go, Crocs was much more of a faddish type thing. LULU may have its margins and growth clipped in the future due to competition or execution issues, but the clothes are generally pretty classic so I don't see the fad risk. At least not as much as weird-looking rubber shoes...

    However, the folks at Motley Fool Rule Breakers are fans of LULU, as is Fool Rex Moore who bought it for his Rising Stars portfolio (http://www.fool.com/investing/high-growth/2011/03/23/rising-..., which, by definition, means that The Motley Fool owns shares.

    Matt

  • Report this Comment On April 07, 2011, at 2:17 PM, TMFKopp wrote:

    @peters46

    "The only thing wrong with the advice is that someone might take it literally and not see any reason to do due diligence."

    That is a bigger issue than you might think, so kudos to you that you dig into the business and financials.

    "Please answer this question - why do some people pay in order to advertise a product? E.g., why do some people pay to wear shirts that advertise Coke or Apple or running shoes?"

    Shared cultural identity. We're a nation of consumers and so brands end up meaning more than just an identifier of who made the product you're about to use. Throwback logos in particular are fun b/c they're a reminder of those good ol' days long past.

    Matt

  • Report this Comment On April 08, 2011, at 2:47 PM, hbofbyu wrote:

    Advertising: It's easier to tinker with perception that to try and alter reality.

    I don't own Lulu but it seems to be building a solid brand much like UnderArmor did. If you want to see a fascinating lecture about the power of perception check this out:

    http://www.ted.com/talks/rory_sutherland_life_lessons_from_a...

    If you don't have 16 minutes for the whole thing, jump to the 12:00 minute mark.

  • Report this Comment On April 09, 2011, at 11:33 AM, ultima64 wrote:

    I wonder what the Buffet Ratio is for HGG which seem to have tanked.

  • Report this Comment On April 10, 2011, at 4:42 AM, Sunny7039 wrote:

    Oh come on!

    Buy all that you know, or buy only what you know?

    (If you know X, then buy X . . . or . . . if you don't know X, then don't buy X?)

    Yeah, not knowing basic logic could always cost you big. Worse yet, if you do know, but your emotions cause you to confuse the two.

    Maybe an article on how to tune out the emotional static would be nice? Thanks, because that is advice we all need. Or at least I sure do.

  • Report this Comment On October 13, 2011, at 2:27 PM, WikiCPA wrote:

    Sunny,

    I feel you, I actually found a new tactic to keep me sane. I keep a little sheet next to my trading desk, and next to the symbols of my positions, i put a one or two-liner to remind myself why i bought into what i bought. This has helped me with BAC lately ("BAC - bought long, too many customers, regardless of toxic mortgages, gov't won't let it fail). Seeing numbers go down and up, it's kinda relaxing to be reminded of your investment decision. I see emotion as an impulse in my stock trading, in the morning I would feel "wow i was an idiot to have ever bought BAC" but by the afternoon, my senses come back and i think "this too shall pass"

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