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If you're lucky, stocks warn you of their dangers upfront.
Post-bubble, every armchair stock picker can spot the lingering danger in homebuilders. Like the packages containing its tobacco products, Altria virtually screams its litigation risks in a big, bold point size. And the 2009 bankruptcy of GM serves as an easy object lesson for what can go wrong in the globally cutthroat, capital-intensive car industry.
Believe it or not, homebuilders, tobacconists, and car manufacturers are relatively easy to dissect. We know that we have to factor in a discount to make up for the uncertainty in housing, litigation, and consumer demand for American-built cars.
As with people, it's the quiet ones lurking in the corner you have to worry about. The companies that seem to report all the right things just may be hiding serious bombshells. These are the ones that can shatter your returns and cripple your retirement savings.
Allow me to explain with a few examples.
Bombshell No. 1: The trumped-up dividend
Few things in investing give folks more comfort than a warm dividend stream. And the bigger, the better. When a company sends you money regularly, you can see the tangible gains from your investments. And unlike earnings (or even free cash flow), dividends can't be manipulated.
Or can they?
Well, in an ideal world, a company does well for itself and turns a nice profit. It then shares some of these profits with shareholders through dividends. But a company can also get its dividend money from less impressive sources than earnings. It can borrow more money from banks or bondholders. Or it can float new shares in the company. The former increases bankruptcy risk; the latter dilutes your stake in the company.
Of course, some companies have no choice. Mortgage REITs have to return 90% of their profits to shareholders to keep their tax-efficient REIT status. So it's not necessarily a red flag that over the past three years, 15.6% dividend payer Resource Capital (NYSE: RSO ) brought in twice as much cash from stock sales as it paid out in dividends. Or that the figure for 18.8% payer American Capital Agency (Nasdaq: AGNC ) is more than 10 times. Since they can't meaningfully reinvest their profits, selling more shares or leveraging up is what they have to do when they want to invest for growth. And, passing the initial growth test, sales and profits have been growing for each.
But when you're not a REIT and your sales and profits have been tanking, it's a major danger sign when stock sales outpace dividends. Look no further than Nordic American Tanker Shipping (NYSE: NAT ) for this scenario. In its past five full fiscal years, it has paid out a hefty $571 million in dividends. That's more than its net income total or its free cash flow total. But it's not more than the $940 million in stock it floated. That's why I don't find its 5.3% dividend yield compelling at all.
Bombshell No. 2: Hidden balance-sheet gremlins
With the rise of 401(k)s, many investors don't even think about the risk that unfunded pensions cast over companies. Warren Buffett once wrote: "There is already far more debt in corporate America than is conveyed by conventional balance sheets. Many companies have massive pension obligations geared to whatever pay levels will be in effect when present workers retire."
Look no further than the defense industry for examples. Already, highly leveraged players Lockheed Martin (NYSE: LMT ) (133% debt-to-equity) and Boeing (NYSE: BA ) (292% debt-to-equity) juice those debt obligations with comparable to more-than-comparable underfunded pension amounts. It's a similar story on a smaller scale at Rockwell Collins (NYSE: COL ) , whose leverage isn't as low as its 34% debt-to-equity ratio would indicate.
Bombshell No. 3: Deceptively low P/E ratios
Value investors are taught over and over again to be greedy when others are fearful. As Greece faces an acute debt crisis, the market's definitely fearful of Greek banks. Some investors, hoping to take advantage, are looking into National Bank of Greece (NYSE: NBG ) , which continues to be profitable through it all. The market is assigning it a P/E ratio of 8.2 and a price-to-book ratio of 0.5. Both of those ratios are dirt cheap, but to blindly throw money at low multiples can be a huge mistake.
Take the time to assess the magnitude of its potential bombshell: National Bank of Greece's gross exposure to government bonds is 218% of its book value. In other words, any negative events for Greek debt (not just outright default) can have a crippling effect on NBG.
That doesn't mean NBG won't prove to be a profitable greedy-when-others-are-fearful situation (I continue to monitor it as its stock price slides), but throwing money at a stock without assessing the potential bombshell is gambling, not investing.
The same goes for all these hidden bombshells. We need to be brutal when we think through possible downsides to make sure we're not overpaying on optimism. That's why, when I recently made a stock recommendation, I started my write-up by listing 10 reasons you shouldn't buy the stock. You can see my stock pick and four others by downloading our free report: "5 Stocks The Motley Fool Owns -- and You Should Too."