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 Ford Motor (NYSE: F ) is trading at lows that come about once every decade -- and yet it's still not a great idea to invest. The company is in a horrible economic situation, it's getting pummeled by superior foreign builders, it supports tons of debt, and it hasn't exactly proved to be a smart capital allocator over the course of time.
Why would you even consider buying Ford when you can get a company like Novartis (NYSE: NVS ) -- a high-quality operation with a very strong balance sheet – at just 15 times earnings? Ford 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 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. Consider resort businesses like Wynn Resorts (Nasdaq: WYNN ) and Las Vegas Sands (NYSE: LVS ) , for example, that are constantly burning tremendous amounts of cash to build the next big thing.
Palm (Nasdaq: PALM ) , yet another example, has been in the news 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 new, hit phone costs money (especially one that is 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 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.
Exelon, for instance, has considerable hurdles in the near term, with aging infrastructure, large amounts of regular capital expenditures, and very significant cash obligations related to near-term debt obligations. This is a situation that should merit a second look.
I would be similarly concerned if I held a company like Sprint Nextel (NYSE: S ) . Though the company is making cash, it carries a whole lotta debt, some of which comes due fairly soon. This is a troublesome situation.
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 (NYSE: BAC ) to Wells Fargo. But it will also indirectly affect any company that expects its customers to buy on credit. This ranges from car manufacturers like Toyota Motor to big-box electronics-items makers like Sony. 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.
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This article was originally published Dec. 5, 2008. It has been updated.
Fool contributor Richard Gibbons has no positions in any of the securities mentioned. Novartis is a Motley Fool Global Gains pick. Sprint Nextel is an Inside Value choice. The Fool's disclosure policy is anything but doomed.