The amazing thing about this market is that there are so many cheap stocks. The problem with this market is that there are so many companies that could really blow up on investors.
Your investing success in the next year will be largely determined by your ability to sniff out and avoid losers. With that in mind, here are some suggestions for stocks you should avoid.
Right now, you should avoid money-losing businesses, companies that need high growth to justify their high earnings multiples, start-up companies that are dependent on the growth of new markets, and other speculative stocks.
Right now, you can find solid, blue-chip stocks that are undervalued by unprecedented amounts. If you can buy a stock that should be trading at double or triple the price, why would you want to risk your money on a stock with less probable gains? In such an environment, speculative bets just don't make sense.
For instance, right now General Motors is trading at multi-decade lows -- and the stock still isn't cheap. The company is projected to lose money as far as the eye can see, and it's had to beg for government assistance. Why would you even consider buying GM when you can get Diageo (NYSE: DEO ) -- a high-quality operation with proven cash-generating abilities -- at just 13 times trailing earnings? GM simply doesn't make sense.
When even established, well-capitalized companies are seeing strong headwinds, stay away from the companies that aren't well-positioned.
Sometimes businesses report earnings but don't produce cash. Sometimes earnings are recognized as an accounting gain immediately, but the cash comes in later. Sometimes capital expenditures can exceed the operating cash flows. None of these should give you confidence in a market like this one.
In good times, cash-poor businesses can borrow money or sell equity to tide them over until the business starts producing cash. But in more challenging times, they may only be able to borrow at high rates, sacrificing the long-term cash flows of the company to service the debt. Worse, they may not be able to borrow at all -- and thus be forced into bankruptcy.
It may not even be the result of poor management -- some industries are chronically cash-poor because of their capital-intensive nature. Airplane manufacturers like Boeing (NYSE: BA ) and Embraer (NYSE: ERJ ) , for example, often have to spend their profits on the next generation of planes just to compete.
Here's another example: First Solar has been profitable and growing quickly. But its operations are burning cash despite big advance payments from customers. Of course First Solar needs to make capital expenditures to grow, and thus far, it's worked out OK. But the lack of free cash flow is nevertheless worrisome in an environment in which cash may not be forthcoming to make up for significant shortfalls.
Near-term debt maturities
The credit crisis we're in means lenders are risk-averse and attempting to reduce their leverage. That means that even profitable companies can run into trouble if they have debt maturing that they can't pay off from cash or rollover.
Media giant CBS, for instance, has decently strong funds from operations, but it's facing a milestone in 2010 as $1.6 billion in debt comes due. To add to the problem, advertising spending is being choked off, and yet the company still has ambitious plans for growth -- but where will this money come from? If I were a shareholder, I would be seriously concerned about the possibility of massive dilution.
I would be similarly concerned if I held a company like Blockbuster (NYSE: BBI ) -- burning cash, lots of debt, and not a whole lot to work with in the bank account.
Given the tightening of corporate credit across the board, stay away from companies with significant debt coming due anytime soon.
Broken business models
Because credit is the grease of the business world, the credit crisis means the rules of the game have changed. Business strategies that worked two years ago, like depending on borrowed money, are now much less feasible.
Consider securitization, the practice of pooling loans into bond-like securities and selling them to investors. The housing bust has caused the value of mortgage-backed securities to plunge, and other securities have done the same. Consequently, investors are reluctant to buy -- and while these securities are unlikely to go away, they may become more regulated. They'll certainly be much harder to sell, and therefore less profitable, in the future.
It's apparent that this change will directly affect most lenders, from Bank of America to Wells Fargo (NYSE: WFC ) . But it will also indirectly affect any company that expects its customers to buy on credit. This ranges from manufacturers like Honda Motor (NYSE: HMC ) to big-screen television distributors like Best Buy (NYSE: BBY ) . If that hybrid car loan is harder to securitize, consumers will be charged higher interest rates, and that will in turn reduce the demand in general -- and thus for all of the parts, supplies, and labor that go into those vehicles.
So you should be cautious of companies that have business models that could be adversely affected in an environment where it's hard to borrow money at reasonable rates.
The Foolish bottom line
All that being said, don't just blindly avoid any stock that has one of these flaws. (Indeed, Best Buy is a recommendation in our Inside Value service.) Do, however, investigate further. Sometimes the issue will be catastrophic for shareholders, but sometimes it will simply be a small hurdle affecting a fraction of the overall business.
These are just some of the issues we examine at Motley Fool Inside Value while deciding whether a stock is truly cheap or just a value trap. To see our favorite stocks in this market, take a 30-day guest pass to Inside Value. Click here to get started -- there's no obligation to subscribe.
This article was originally published on Dec. 5, 2008. It has been updated.
Fool contributor Richard Gibbons has no positions in any of the securities mentions. The Fool owns shares of Best Buy. Best Buy is a Motley Fool Inside Value pick. Diageo is an Income Investor selection. Best Buy and Embraer are Stock Advisor recommendations. The Fool's disclosure policy is anything but doomed.