Doomed Stocks You Should Avoid

Editor's note: In an earlier version of this article, we mistakenly wrote that CBS faces $1.4 billion in debt due in 2010. We regret the error.

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.

Speculative companies
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, it wasn't long ago that General Motors was trading at multidecade lows -- and quite clearly the stock still wasn't cheap enough for any prudent investor. Why? Well, the company was projected to lose money as far as the eye can see, at the same time it was begging for government assistance.

Why would you even consider buying GM when you could have gotten a company like Walt Disney (NYSE: DIS  ) -- a high-quality operation with amazing stores of intellectual property -- at 9 times its forward earnings multiple? GM simply didn’t make sense. The same goes for today's situation.

When even established, well-capitalized companies are seeing strong headwinds, stay away from the companies that aren't well-positioned.

Cash-poor businesses
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. Semiconductor companies, for example, often have to spend their profits on the next generation of equipment just to compete.

First Solar (Nasdaq: FSLR  ) , for instance, 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 where cash may not be available 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 roll over.

Media giant CBS (NYSE: CBS  ) has decently strong funds from operations, but more than $1 billion in debt is coming due in the next two years. To add to the problem, advertising spending is being choked off 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 dilution.

I would be similarly concerned if I held Level 3 Communications (Nasdaq: LVLT  ) ; it's burning cash with significant amounts of capex, lots of debt (a good portion of which is coming due within in the next two years), and relatively speaking, not a whole lot of cash to work with in the bank account.

Given the tightening of corporate credit across the board, I'd 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 affect most lenders, from Bank of America (NYSE: BAC  ) to M&T Bank (NYSE: MTB  ) . But it will also affect manufacturing companies like Harley-Davidson (NYSE: HOG  ) . If motorcycle loans are harder to securitize, consumers will be charged higher interest rates, and that will in turn reduce the demand for Hogs 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.

Fool contributor Richard Gibbons owns shares of Harley-Davidson. He does not have a position in any of the companies mentioned in this article. Disney is a Motley Fool Inside Value and Stock Advisor recommendation. First Solar is a Rule Breakers choice. The Fool's disclosure policy is anything but doomed.


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  • Report this Comment On July 24, 2009, at 8:42 AM, ron153 wrote:

    Level 3 is no longer burning cash, it is cash flow positive. Its two largest investors, who control about 40% of the stock, are Mason Hawkins and Prem Watsa, two of the most successful investors around. Bandwidth usage is exploding, Level 3 is the low cost provider. The company has recently entered into some significant new alliances. Thjis is an excellent long term investment. The author is either woefully misninformed or intentionally misleading.

    Ron Beasley

    www.rwbi.net

  • Report this Comment On July 25, 2009, at 7:17 PM, UltraContrarian wrote:

    LVLT is trash. Revenue has consecutively fallen the last 5 quarters. And as Richard states, their cost of capital will likely rise given the credit environment.

    As for being the low cost provider - in technology, the proven way to make a lot of money is to position yourself as high value, not low price. Look at the incredible returns achieved in the past at Apple, RIMM, Microsoft, Adobe, etc. Compare that with the amount of shareholder value destroyed by LVLT, GLBC, and all the other internet infrastructure bubble mistakes.

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