4 Portfolio-Shrinking Stocks

As investors, we're always on the lookout for stocks that will swell our portfolios -- like Amazon.com (NASDAQ:AMZN) and its whopping 162% gain in 2009. But as 2008 reminded us, plenty of stocks will not only fail to deliver blockbuster returns for us, but also significantly shrink in value, taking a chunk of our future nest eggs with them. I've rounded up four nefarious types of stocks that Fools should beware.

1. Penny stocks
No list of stock dangers would be complete without penny stocks. They're the quintessential rookie investor mistake, although many experienced investors fall for them, too. These puny equities are usually tied to unproven companies, and plagued by volatile price moves. Easily manipulated, they often wipe out innocent investors lured by suggestions that the company will soon cure cancer or strike oil (literally).

2. High P/Es
High price-to-earnings (P/E) ratios are a potential red flag, since they suggest that a stock may be overvalued. Don't just look at a P/E in isolation, though; the metric varies widely by industry. Compare a stock's P/E to its historic P/E range. With that in mind, which of the following stocks look risky to you?

Data: Motley Fool CAPS.

J.C. Penney is trading near the high end of its range; Nokia has far surpassed its high; but Johnson & Johnson's P/E seems relatively low. Don't judge an entire company just one one number, though. It's important to dig deeper into a promising company's earnings and overall growth, since faster-growing companies usually merit higher P/Es.

3. Tons of debt
If a company groans beneath a pile of debt, ask yourself why it's needed to borrow money in order to operate or grow. Consider peeking at the footnotes to its financial statements to see what its interest rates are. Compare its debt to its equity, to see how much debt the company is piling on. Then compare its net debt to its earnings before interest, taxes, depreciation, and-amortization (EBITDA), to gauge how easily it will be able to pay off its debt. Beware of debt-to-equity ratios above 1 and EBIT-to-net debt ratios above 5.

In the following examples, all four companies carry significant debt relative to their assets, though all except for Caterpillar are earning enough money to comfortably pay down that debt:

Data: Motley Fool CAPS and Capital IQ, a division of Standard & Poor's.

4. Enormous yields
Another potential red flag is a very high dividend yield. Philip Morris's recent 4.7% or GlaxoSmithKline's 4.8% are hefty, but not eye-popping. Fools might worry more about a company such as CPFL Energia, with a recent yield around 7% and far more debt than cash on its balance sheet. Importantly, its free cash flow payout ratio is 160%, indicating that the company doesn't generate enough cash to pay its whopping yield and still meet its other capital needs.

Dividend payers are some of the most powerful wealth-growers you can add to your portfolio. Just bear in mind that they're not all alike.

We'd love to help you zero in on compelling dividend-paying stocks with a free trial of our Motley Fool Income Investor newsletter. Click here for a 30-day peek at all our current picks.

As you pore through the piles of great stocks on sale, remember to keep your eyes open for red flags. If you don't, you might see your dreams of portfolio growth shrink away to nothingness.

Longtime Fool contributor Selena Maranjian owns shares of Johnson & Johnson. Nokia is a Motley Fool Inside Value pick. Amazon.com is a Motley Fool Stock Advisor selection. Philip Morris International is a Motley Fool Global Gains recommendation. Johnson & Johnson is a Motley Fool Income Investor recommendation. The Fool has a financial position in GlaxoSmithKline and Oracle. The Motley Fool is Fools writing for Fools.