FOOL ON THE HILL
Avoiding Investing Traps

The key to successful long-term investing lies in avoiding big mistakes, rather than swinging for the fences. Here are six guidelines that can help you earn a reasonable rate of return, while avoiding disaster.

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By Whitney Tilson
May 1, 2002

Over the past 18 months, I have made 63 specific recommendations to avoid particular stocks. As of yesterday's close, 57 of them (90%) have fallen in price, and the average decline is 39% (click here to see the performance of all of my pans and picks).

Luck? To some extent, certainly. I don't ever expect to be right 90% of the time when it comes to predicting something as uncertain as future stock prices. But I'd like to think there's some skill and discipline involved as well. I invest with a set of mental guidelines that helps me identify stocks that are likely to rise and, far more importantly, avoid those that might blow up. It's the latter -- avoiding big mistakes -- that is the key to successful long-term investing, not (contrary to popular opinion) picking home run stocks. Yet in the greedy and/or na�ve pursuit of quick riches, millions of investors swung for the fences and ended up losing a significant fraction of their savings over the past two years. How sad -- and how avoidable!

Here are six simple rules that guide me:

1. Shun the crowd.
Run far, far away from the hottest stocks in the hottest sectors, which are invariably priced for perfection. While the occasional stock -- like Krispy Kreme (NYSE: KKD) -- can defy gravity (for a while, anyway) almost no company achieves perfection, and the odds of picking one that does are tiny. It's far safer and more profitable to invest in stocks that are either well-known but hated, or obscure and unknown (for more on this topic, see my article, The Cocktail Party Test).

Bashing tech stocks is getting old (though, in general, they're still significantly overvalued) so I'll instead warn investors to stay away from the more mundane sectors that growth-addicted investors piling out of tech are piling into, like restaurants. Yes, restaurants. Companies like Tricon (NYSE: YUM), Wendy's (NYSE: WEN), and Jack in the Box (NYSE: JBX) are at or near 52-week highs -- probably deservedly so, as they were undervalued previously. The stocks to avoid in this sector are the high-growth darlings like Krispy Kreme, Panera Bread Company (Nasdaq: PNRA), and P.F. Chang's China Bistro (Nasdaq: PFCB). These are all decent companies that are growing rapidly, but their valuations are ridiculous, at 62x, 51x, and 46x this year's estimated earnings, respectively.  I wouldn't touch any of them at half their current price.

2. Look for consistently positive cash flow and beware of debt.
Companies that generate consistently positive cash flow can control their destinies and reward shareholders in so many more ways than companies that must rely on often-fickle capital markets. Consider two of the three best-performing stocks in the S&P 500 in 2001, Office Depot (NYSE: ODP) (which I owned) and AutoZone (NYSE: AZO). Both hit multi-year lows in late 2000 and Wall Street sentiment couldn't have been worse, but they were buying back mountains of stock and investing in their businesses. They were able to maintain moderate debt levels because, even at the low point, they had significant positive free cash flow.

A similarly beaten-down stock today, WorldCom (Nasdaq: WCOM), is in a more difficult situation because of its barely positive free cash flow and high debt level. Last year, WorldCom (including subsidiary MCI Group (Nasdaq: MCIT)) generated $8.0 billion of operating cash flow, but $7.9 billion of capital expenditures consumed nearly all of it. Weak free cash flow, combined with a perilously high net debt level of $27.9 billion as of the end of Q1, has fueled concerns that WorldCom might go bankrupt, so not surprisingly the stock has been obliterated. Could it be a buy at today's levels?  Perhaps, but I know with certainty that there are easier, less-risky investments I can make. (For further thoughts, see Don't Forget Debt.)

3. Avoid serial acquirers and big acquisitions.
I could also use WorldCom as an example of an acquisition strategy gone bad, but let's instead look at Tyco (NYSE: TYC), a serial acquirer, and AOL Time Warner (NYSE: AOL), the result of a mega-merger. I took a lot of flak when I warned investors last November about these two stocks, but they've fallen 62% and 42%, respectively, since then. Making many small acquisitions or one big one are both fraught with peril, yet some CEOs insist on engaging in such behavior. There's not much the average shareholder can do about it -- other than sell the stock, of course.

Today, my least-favorite acquisition/merger is Hewlett-Packard (NYSE: HWP) and Compaq (NYSE: CPQ). Two stones tied together still sink, so avoid this one like the plague.

4. Don't speculate.
Among the stocks I've panned, Sunrise Technologies (OTC BB: SNRSE), Active Power (Nasdaq: ACPW), and Loudcloud (Nasdaq: LDCL) were -- and are -- pure speculations. None of these companies has ever earned a penny of operating cash flow, much less free cash flow, and I question whether they ever will. Not surprisingly, these stocks are down 96%, 82%, and 65%, respectively, since I first warned about them. Keep in mind Peter Lynch's admonition in Beating the Street: "Long shots almost always miss the mark."

The speculative stock I suggest avoiding at this time is chip design software maker Magma Design Automation (Nasdaq: LAVA), which trades at a big valuation premium to its larger, stronger, highly profitable competitors.

5. Don't bet against the shorts.
Speaking of Magma, according to the company profile on Yahoo! Finance, 35% of its tradable shares (i.e., the float) are sold short -- meaning many investors are betting the stock will decline. A high short interest should always be a huge warning flag, as the short sellers I am aware of are extremely smart and analytically rigorous, in marked contrast to the majority of Wall Street analysts (read: cheerleaders). Shorts aren't always right, but if you're going to bet against them, you'd better be awfully sure of yourself.

Other stocks that have crossed my radar screen with a high short interest include PolyMedica (Nasdaq: PLMD) (66% of the float is sold short), Black Box (Nasdaq: BBOX) (34%), AstroPower (Nasdaq: APWR) (34%), and Take-Two Interactive (Nasdaq: TTWO) (32%). Sure, the shorts might be wrong about one or more of these companies, but I don't really care. I simply avoid controversial, messy situations like these.

6. Keep it simple.
I can't say it any better than Warren Buffett, who wrote in his 1989 annual letter:

"Easy does it. After 25 years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers. The finding may seem unfair, but in both business and investments it is usually far more profitable to simply stick with the easy and obvious than it is to resolve the difficult."

Conclusion
If you stick to these guidelines, you have a good chance of compounding your money at a reasonable rate. If you violate them, I can assure you from painful personal experience that you are inviting trouble.

Guest columnist Whitney Tilson is Managing Partner of Tilson Capital Partners, LLC, a New York City-based money management firm. He did not own shares of the companies mentioned in this article at press time. Mr. Tilson appreciates your feedback at Tilson@Tilsonfunds.com. To read his previous columns for The Motley Fool and other writings, visit http://www.tilsonfunds.com/.