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:

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.

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.

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.