The amazing thing about this market is that despite this recent market tear, there are still so many cheap stocks. The problem with this market is that there are so many companies that could still really blow up in investors' faces.
Your investing success in the years to come 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, stocks like Citigroup (NYSE: C ) and Bank of America are still trading far, far lower than they ever were three years ago -- but they're still not cheap. God knows what these companies are still holding in their books; it's really anyone's guess what these companies are worth. Why would you even consider these nebulous banks when you can get Costco (Nasdaq: COST ) -- arguably one of the strongest companies in the world -- trading for just 18 times forward earnings?
When even established, well-capitalized companies are facing strong headwinds, stay away from businesses 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. Semiconductor companies, for example, often have to spend their profits on the next generation of equipment just to compete.
LDK Solar (NYSE: LDK ) , for instance, has been profitable and was previously growing quickly. But it's burning cash with its huge capital expenditures. Of course LDK needs to make capital expenditures to grow, and thus far, it's been successful selling shares to raise cash. But the lack of free cash flow is nevertheless worrisome in an environment in which cash is not flowing freely to make up 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.
Retailer Talbots, for instance, is facing a sticky situation, with a cash-burning business and a significant amount of debt coming due in the next two years. In an environment where even more trendy brands like Gap (NYSE: GPS ) and Abercrombie & Fitch (NYSE: ANF ) are getting spanked, what happens to a company that can't make money or pay back its debt?
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 affect most lenders, from Capital One Financial (NYSE: COF ) to General Electric. But it will also affect manufacturing companies like Ford (NYSE: F ) . If car loans are harder to securitize, consumers will be charged higher interest rates, and that will in turn reduce the demand for Ford's vehicles -- 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 Dec. 5, 2008. It has been updated.
Fool contributor Richard Gibbons also avoids narwhals, nail guns, and knaves. Costco is a Motley Fool Inside Value pick, Stock Advisor selection, and Fool holding. The Motley Fool has written bear put spreads on Abercrombie & Fitch. The Fool's disclosure policy is anything but doomed.