The amazing thing about this market is that 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.
Your investing success in the next few years will be largely determined by your ability to sniff out and avoid the 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 depend 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 AIG (NYSE: AIG ) and Fannie Mae (NYSE: FNM ) 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 really worth. It's really anyone's guess.
Why would you even consider these nebulous financials when you can get Johnson & Johnson (NYSE: JNJ ) -- arguably one of the strongest companies in the world -- trading for just 13 times forward earnings? 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 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.
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, for instance, has been profitable and had been growing quickly. But it is burning cash with its huge capital spending. Of course, LDK needs capital expenditures to grow, and thus far, it has 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 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 roll over.
Retailer Talbots, for instance, is facing a sticky situation, with a significant amount of debt coming due in the next two years, and a business that is burning cash. In an environment where even more trendy brands like American Eagle (NYSE: AEO ) and Under Armour (NYSE: UA ) are getting spanked, what happens to a company that can't make money and can't 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 Citigroup to General Electric. But it really affects all companies whose products (and products of products) are purchased with credit -- from homebuilders, to home appliance makers like Whirlpool (NYSE: WHR ) , to car manufacturers and even car product manufacturers like Garmin (Nasdaq: GRMN ) .
If loans in general are harder to securitize, consumers will be charged higher interest rates. In turn, that will reduce the demand for any related good -- and thus for all of the parts, supplies, and labor that go into those goods.
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 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. Under Armour is a Motley Fool Hidden Gems and a Rule Breakers selection. Johnson & Johnson is an Income Investor pick. The Fool owns shares of Under Armour. The Fool's disclosure policy is anything but doomed.