FOOL ON THE HILL
Stocks to Avoid

What sort of companies is Whitney Tilson careful to avoid? In this article, he discusses three: money-losers that might be headed to zero, speculative companies with extreme valuations, and weakening blue chips.

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By Whitney Tilson
January 16, 2001

While most investors focus their energies on picking stocks that they hope will be big winners, an equally important part of successful long-term investing is being aware of -- and avoiding -- dangerous stocks and investment strategies. As Warren Buffett wrote in his 1996 annual letter to shareholders:

"We try to 'reverse engineer' our future at Berkshire (NYSE: BRK.A), bearing in mind... [the] dictum: 'All I want to know is where I'm going to die so I'll never go there.' (Inverting really works: Try singing country western songs backwards and you will quickly regain your house, your car and your wife.) If we can't tolerate a possible consequence, remote though it may be, we steer clear of planting its seeds. That is why we don't borrow big amounts and why we make sure that our [super-catastrophe insurance] business losses, large though the maximums may sound, will not put a major dent in Berkshire's intrinsic value."

With this in mind, I'd like to highlight three types of stocks that I almost always avoid:

  • Weak, money-losing companies, generally with stocks below $5, in which bankruptcy is a real possibility.
  • Speculative, money-losing companies that have extreme valuations, often due to excitement over some type of emerging technology. In particular, beware of third- or fourth-tier "me-too" companies.
  • Blue-chip companies that are showing clear signs of weakness (especially on the balance sheet and cash flow statement) but retain high valuations due to their image as stalwarts -- and, in many cases, accounting tricks that maintain the illusion of strength.

If you disagree with my assessments of some of the stocks I mention in this column, that's fine -- maybe I'll be wrong -- but don't send me emails accusing me of trying to drive a stock down for my own gain. I don't short stocks.

Stocks heading to zero
One of the biggest mistakes investors make is assuming that because a stock has fallen from $15 (or $150) to $5, it's "cheap." Ha! There's an old saying that short sellers make most of their money on stocks as they fall from $5 to $0. I also recall reading somewhere -- please email me if you know the source -- that 80% of all stocks trading below $5 apiece do not exist within five years.

Last year provided countless examples of seemingly cheap stocks that became much, much cheaper: Webvan (Nasdaq: WBVN), PlanetRx, Iridium, and priceline.com (Nasdaq: PCLN) come to mind. What about an example today? I think Sunrise Technologies International (Nasdaq: SNRS), which makes a laser used in eye surgery, is a pretty good bet to go to zero. I have posted my reasoning on the Fool on the Hill discussion board.

Speculative, money-losing companies with extreme valuations
It's human nature to be attracted to exciting new technologies, but I would argue that it's generally unwise for the average person to invest in early stage companies -- especially at high valuations -- that do not have proven technologies or business models, much less profits or even revenues. This type of investing was once left to experts, such as venture capitalists, who could properly evaluate the many risks and, equally importantly, invest at low valuations.

But in recent years, the bull market attracted a flood of gullible (and perhaps greedy) first-time investors who were willing to speculate in such stocks. Not surprisingly, investment banks shamelessly eliminated even the most basic standards and flooded the market with IPOs for companies that had no business going public (or, in some cases, existing at all). Some of these companies, like Pets.com, went bankrupt the same year in which they went public. Others, like Corvis (Nasdaq: CORV), had no revenues. Unbelievable.

The next time you're tempted to invest in this type of company, consider that Buffett has built the greatest investment track record in history over the past half century without ever investing in such stocks.

Among companies that retain rich valuations, my least favorite companies include Manugistics (Nasdaq: MANU) -- which I have written about elsewhere; see my website (http://www.tilsonfunds.com/) for links -- Active Power (Nasdaq: ACPW) and, though profitable, Krispy Kreme (Nasdaq: KREM). The combination of investors' perception that this could be another Starbucks (Nasdaq: SBUX) and a limited float (soon to nearly triple due to a secondary offering and an ending of restrictions on insiders' ability to sell) caused Krispy Kreme's stock to soar from its $21 IPO price last April to a high last November of $108.50. It closed Friday at $67.31, equal to a rich 74x trailing EPS.

I believe the analogy with Starbucks is faulty. After water, coffee is the most-consumed beverage in the world and is addictive. Doughnuts are, well, doughnuts. Also, Starbucks faced little competition, whereas Krispy Kreme, with 181 stores today, faces many competitors, including Dunkin' Donuts, which has nearly 5,000 stores in 41 countries.

Weakening blue chips
Was it less than a year ago that Lucent (NYSE: LU) was the most widely held stock in America, and Kodak (NYSE: EK), Xerox (NYSE: XRX), AT&T (NYSE: T), and WorldCom (Nasdaq: WCOM) were considered to be blue-chip stalwarts? These companies had most or all of the following characteristics that should have tipped off investors: high and/or increasing debt, weakening balance sheets leading to declining or negative free cash flows, aggressive accounting, and a reliance on acquisitions for growth.

What blue-chip companies today best meet these tests? In my opinion -- I'm bracing myself for the hate emails -- IBM (NYSE: IBM) and General Electric (NYSE: GE). Both meet every one of these tests, other than IBM not being particularly acquisitive. Here's the data on each company's rising debt and declining cash flows (all figures in millions; free cash flow is equal to operating cash flow minus capital expenditures):

IBM            Q3 99     Q3 00   % change
Cash           6,026     3,033     -50%
Debt          27,903    29,371      +5%
Net debt      21,877    26,338     +20%

IBM          Q1-3 99   Q1-3 00   % change
Revenue       63,366    62,780      -1%
Net income     5,623     5,423      -4%

Operating
cash flow    6,760     4,548     -33% Capital
expenditures   3,694     2,907     -21% Free
cash flow      3,066     1,641     -46% GE             Q3 99     Q3 00   % change
Cash           6,112     8,781     +44% Debt         186,348    197,710     +6% Net debt     180,236   188,929      +5% GE           Q1-3 99   Q1-3 00   % change Revenue       78,775    94,872     +20% Net income     7,628     9,150     +20% Operating
cash flow   16,130    11,261     -30% Capital
expenditures   8,629     9,748     +13% Free
cash flow      7,501     1,513     -80%

I don't know which stock scares me more. IBM's top- and bottom-line growth is nonexistent, net debt is rising, and cash flows are falling. I'm not sure what to make of IBM's lower cap ex in 2000 -- this could be prudent or a real warning flag -- but had cap ex remained constant year over year, free cash flow would have fallen 72% rather than 46%. At least the stock is only trading at 23x trailing EPS.

GE is showing strong top- and bottom-line growth -- quite remarkable, given its size -- and I don't worry much about the high and slightly rising debt, as this is almost entirely associated with GE Capital. But cash flows are plunging, its CEO -- one of the greatest in history -- is retiring, and the company has to digest Honeywell, a troubled company and by far GE's largest acquisition ever. Making the stock even more risky is its rich price of 37x trailing EPS.

-- Whitney Tilson

Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit Tilsonfunds.com.