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.
In this kind of economic climate, 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 continues to beg for government assistance. Why would you even consider buying GM when you can get Fortune Brands (NYSE: FO ) -- a high-quality operation with a tremendous balance sheet -- at just 11 times 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. Semi-conductor companies like Intel (Nasdaq: INTC ) and airlines like Delta (NYSE: DAL ) , for example, often have to spend their profits purchasing and maintaining expensive equipment.
Palm (Nasdaq: PALM ) , for instance, has been working on the up and up recently, especially with its new device, the Pre, generating a lot of buzz. But its operations are burning more cash than they are bringing in. Developing a hit phone costs money (especially if it's going to battle the iPhone) and that's fine. 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. Beware dilution.
Near-term debt maturities
The credit crisis we're in means that lenders are risk-averse and are 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.
US Airways (NYSE: LCC ) , for instance, has considerable hurdles in the near-term horizon with a large number of planned aircraft deliveries and cash obligations related to near-term debt obligations. To add to the problem, folks just don't have the discretionary income to pick up and travel whenever they like -- where will the money come from to make up for all this? If I were a shareholder, I would be seriously concerned.
I would be similarly concerned if I held a company like MGM Mirage (NYSE: MGM ) -- burning cash, lots of debt, and not a whole lot to work with in the bank account. This is a troublesome confluence of factors.
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. But it will also indirectly affect any company that expects its customers to buy on credit. This ranges from manufacturers like Toyota Motors to retailers like CarMax (NYSE: KMX ) . If that new 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 don't work in an environment where it's hard to borrow money at reasonable rates, businesses are deleveraging and downsizing, and consumers are scaling back.
The Foolish bottom line
All that being said, don't just blindly avoid any stock that has one of these flaws. 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. CarMax and Intel are Motley Fool Inside Value picks. Fortune Brands is a Stock Advisor recommendation. The Motley Fool owns shares of Intel as well as covered calls on Intel. The Fool's disclosure policy is anything but doomed.