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Doomed Stocks You Should Avoid

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, right now Fannie Mae (NYSE: FNM  ) is trading at multi-decade lows -- and the stock still isn't cheap. The company is full of all sorts of question marks and black boxes, and it's begging for government assistance. Why would you even consider buying Fannie when you can get ExxonMobil (NYSE: XOM  ) -- a high-quality operation with undoubted staying power -- at just 11 times earnings? Fannie simply doesn't make sense.

When even established, well-capitalized companies are seeing strong headwinds, stay away from those companies that aren't well-positioned or that you simply don't understand.

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 spending 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 protection.

It may not even be the result of poor management: Some industries are chronically cash-poor because of their capital-intensive nature. Start-up biotechs like Dendreon (Nasdaq: DNDN  ) and InterMute, for example, often have to spend precious capital on research and development for years before developing a product just to compete. As a rule, be very cautious of companies that struggle to generate excess cash -- in times like these, your investment may be at risk.

Near-term debt maturities
The credit crisis we're in means lenders are risk-averse and trying 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.

In this instance, I would be concerned if I held a company like Blockbuster (NYSE: BBI  ) -- which is in a terrible strategic position thanks to Netflix (Nasdaq: NFLX  ) and other digital players. Worse still is that the company carries a massive debt load relative to its size (a big chunk of which comes due in the next year) and meanwhile, the company doesn't have a whole lot of cash to work with in its 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 Toyota Motors 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 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 a beneficial interest in Wells Fargo. Best Buy is an Inside Value pick. Netflix and Best Buy are Stock Advisor recommendations, and the Fool owns shares of Best Buy. The Fool's disclosure policy is anything but doomed.

Read/Post Comments (8) | Recommend This Article (26)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 30, 2009, at 5:21 PM, getrickqk wrote:

    I don't why you would include Dendreon as an example. Yes they struggled for years to carry out their research, but in the end it was a very profitable gains for those investors who had the conviction to buy and hold all these years. So if I followed your rule to stary away I would not have made that huge returns of over 500%.

  • Report this Comment On August 30, 2009, at 7:13 PM, sfkc988 wrote:

    Why listen to them they pretend they know more than we do like Jim Creamer Mad money say they know NOTHING --we put our money where our mouth is --they are the same people say dont buy Citi @ $ 1 or $ 3 and now citi @ $ 5.23 and going higher to $ 6 or $8 longer term $ 12 --Bank of america same thing they say dont buy when there @ $ 3 now is $ 18 longer term @ $ 36 -- we are buying fannie & fredie target $ 5 to $ 6 longer term $ 10 high in 2007 $ 62 -- buy Aig -- @ $ 50 it works out @ $ 2.50 before the reverse split of 20 for 1 the high was $ 69- 2007 Oct as the economy turning around all this stock will have temendous upside of 200 to 400% -in the first place they shouldnt be that low they were selling on fear not fundamental ---same with S&P when it goes down to 666 maybe they should be 850

  • Report this Comment On August 30, 2009, at 10:13 PM, mikecart1 wrote:

    Sorry but comparing XOM and FNM is dumb. If I bought 1000 shares of XOM and FNM in March this year. Today I would of made serious money with FNM while I would of stayed about the same with XOM.

    Great article - NOT!

  • Report this Comment On August 31, 2009, at 3:58 AM, Netteligent09 wrote:

    Once you try out with Netflix, Blockbuster is gone for good.

    Best Buy is speculative, hig risk, and overvalue. There is no reason to justify BBI.

  • Report this Comment On August 31, 2009, at 4:47 AM, BRD2 wrote:

    Why can you not write something positive??? Just because Government backed securities such as FNM, FRE, C, and AIG are doing well does not mean it is a negative or bad direction. A Few months ago, GS, WFC (That you own), and 99% of the other Banks were bailed out by the Government. All you idiot reporters were saying Sell, Sell, Sell, simply because the Government gave them funding.

    Why don’t you take the time write about the “UP TICK” Rule and how as you pointed out in your article that “When the Big Guys” get back from their $200,000.00 Vacations they will set things right and begin to manipulate the Market again without having the “Up Tick” Rule in place. Why can you not write about the SEC Chairman Failure to take action on the “UP Tick Rule” or way her Lawyer were caught doing and manipulating the market with insider trading that was reported several months ago? Write on Substance!!!

    The issue is writers such as yourself make a point of stirring the POT to ensure the Market is Manipulated by speculative discussion. Everyone in America was effected by the “UP TICK” Rule and the Run on the Banks all the other financials in the Market. All the sectors fell off a cliff in a matter of days and weeks. Now that there are promising signs of “HOPE” and these stocks are on the way back. Reporters like yourself decide to manipulate the media. I am sure this is done to push or help your portfolio move forward.

    Once again, the big picture is missed. This all goes back to the “Almighty Dollar” and who can manipulate the system from Reporters to “High Rolling” Hedge Funds and Market/Casino managers that will return after Labor Day as you pointed out to fix the Market…

    Hope you enjoy your JOB!!!!!!!!!!!!!!!!

    Dr. Bill Daniel

  • Report this Comment On August 31, 2009, at 11:24 AM, dojodan444 wrote:

    Motley Fool has been Netlix's "woman" for sometime now, which of course means they have to attack any other rival companies, like Blockbuster. Give it a rest, Fools, you've been beating this same drum over and over. If you like to buy bargain stocks, Blockbuster is certainly that. There still is a need for stores, not everyone wants to rent online, and Netflix has no stores. Do you really think Netflix is going to climb higher? That company has NO upside potential, whereas Blockbuster has all kinds of upside potential. We've seen the best Netflix can do.

  • Report this Comment On August 31, 2009, at 12:15 PM, maxmad18 wrote:

    Would you guy's please stop writing negative uninformed, bullschit about Dendreon. You already have people lobbying Yahoo to get you removed from the news links because of your blatant disregard for the facts and obvious feeble attempt just to get a few hits on your site.By the way they have over 287 million in cash, not exactly pocket change! But you failed to include that in your article....Motley Fools about Motley Moron's

  • Report this Comment On August 31, 2009, at 2:12 PM, VeteranWarrior wrote:

    If I listened to the crap spouted by the Fools my little ol 13K investment wouldn't be worth over 40K now. I now own substantial numbers of shares of these cheapies and modest investments in the so-call quality stocks. Guess which are preforming with outstanding results?

    This translates into easier increases than owning a few shares of very high priced stocks. Also, if they should pay dividends again, such as demonstrated by previous history, I will be collecting on a much greater number of shares than a from a few high priced so-called better stocks.

    I will NEVER again purchase shares of high priced stocks which perform meagerly. I would rather purchase thousands of shares of cheap, well performing stocks, especially those with dividend histories. Especially those the government is not likely to let fail!

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