The amazing thing about this market is that there are still plenty of 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 are dependent on the growth of new markets, and other speculative stocks.
Instead, 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, a company like Fannie Mae is still trading way off what may be considered a normal price for the stock -- but 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 a business like Wal-Mart (NYSE: WMT ) or ConocoPhillips (NYSE: COP ) -- both high-quality operations with undoubted staying power -- at just 12 and 7 times forward earnings, respectively? Fannie simply doesn't any make sense.
When even established, well-known companies are seeing strong headwinds, stay away from the companies that aren't well-positioned, or that you simply don't understand.
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 scenarios 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 their debt. Worse, they may not be able to borrow at all -- and thus be forced into bankruptcy.
That may not even be the result of poor management. Some industries are chronically cash-poor because of their capital-intensive nature. Solar guru LDK Solar (NYSE: LDK ) , for example, is doing its best to evolve into a cash flow positive business, but has yet to demonstrate that it can accomplish such an important milestone over a consistent period of time. Given the state of the industry and the nature of the business itself, this isn't terribly surprising.
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 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.
In this instance, I would be very concerned if I held a company like Blockbuster -- a company that is in a terrible strategic position thanks to Netflix, Apple (Nasdaq: AAPL ) , Amazon.com (Nasdaq: AMZN ) and other digital players. Worse still, the company carries a massive debt load relative to its size (a big chunk of which comes due in the next two years) and, meanwhile, the company doesn't have a whole lot of cash to work with in the 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 three 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 readily apparent that this change will directly affect most direct lenders, from Bank of America to Wells Fargo. But it will also indirectly affect any company that expects a customer to buy on credit. This ranges from manufacturers like Toyota to home furnishings and electronics distributors.
Let's not forget the banks like Goldman Sachs (NYSE: GS ) and Morgan Stanley (NYSE: MS ) that attempt to profit on securitized loans by trading them. If that one 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 items and the other corollaries that get involved in the sale.
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 own shares of Goldman Sachs. Wal-Mart Stores is a Motley Fool Inside Value choice. Netflix, Apple and Amazon are Stock Advisor recommendations. The Fool's disclosure policy is anything but doomed.