The amazing thing about the market thus far in 2009 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 over the next few years 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, sitting on what could be the top of a serious market rally, you should be especially careful to 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, it's possible to 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 companies like AIG (NYSE: AIG ) are trading at multi-decade lows -- and the stock still isn't cheap. Why would you even consider buying a rabbit-hole business like AIG when you can get Berkshire Hathaway (NYSE: BRK-B ) -- a high-quality operation with a tremendous balance sheet -- at what are still relatively cheap prices? AIG wouldn't make any 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. Consider Host Hotels and MGM Mirage (NYSE: MGM ) , for example, two companies that are constantly using tremendous amounts of cash to build the next big thing.
Palm (Nasdaq: PALM ) , yet another example, has been working on the up and up recently, especially with its new device, the Pre, generating more than its fair share of buzz. But its operations are burning more cash than they are bringing in. Developing a new, hit phone costs money (especially a phone that is going to battle Apple's iPhone and the $23 billion war chest that company has in its vault). 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 of dilution.
Near-term debt maturities
Uncertain credit environments can often mean 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.
CBS, for instance, has considerable hurdles to clear in the near term under a difficult operating environment and is facing very significant cash obligations in the coming years. If I were a shareholder, I would be concerned.
I would be similarly concerned if I held a company like Sprint Nextel. Though this company is making cash, it carries a whole lotta debt -- some of which comes due fairly soon. This is a troublesome situation, especially as Sprint Nextel continues to trail far behind industry leaders AT&T (NYSE: T ) and Verizon Wireless (NYSE: VZ ) .
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 car manufacturers like Toyota Motors to student loan processors like First Marblehead (NYSE: FMD ) . If that new car loan or student loan is harder to securitize, consumers will be charged higher interest rates, and that in turn will reduce the demand in general. With a car loan, for example, that will thus reduce demand 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 maintains a beneficial position in Berkshire Hathaway. Apple is a Stock Advisor selection. Berkshire Hathaway is a Stock Advisor pick and an Inside Value pick. Sprint is also an Inside Value pick. The Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy is anything but doomed.