And she'll promise you more
Than the Garden of Eden
Then she'll carelessly cut you
And laugh while you're bleedin'

Billy Joel probably didn't write this lyric with the stock market in mind, but he might as well have.

The market holds a naughty collection of companies that look like attractive buys, but are actually headed for disaster. Knowing how to spot them can save you a lot of heartache -- and money.

To give you an idea of what to look for, I'll introduce my ex, a total loser. (When it came to investing, anyway. Ahem.)

Don't be that loser
"Chuck," as I'll call him here, has always bought stocks that seemed poised to soar -- but didn't. Here are three examples:

  • Yahoo! (NASDAQ:YHOO): Back in the 1990s, when people were still saying, "Goog...who?", Yahoo! reigned as the king of search engines. The company had long become a household name by 1999, and it was growing its top line like gangbusters, while showing the potential to be solidly profitable. Things were going so smoothly that by the end of that year, Yahoo! became part of the S&P 500. According to The New York Times, this prompted some mutual funds to sell "shares of the 499 other companies to make room for Yahoo!." Things looked promising. Chuck started buying.
  • Circuit City (NYSE:CC): Whether you need a flat-panel HDTV, a DVD player, or any of the "gotta have it" video games that kids dream of, Circuit City is your store. And let's not forget the zillions of customers who line up every year for the Christmas sales. The stock hit a high in April 2006, after reporting a 65% jump in profits, sizzling holiday sales figures, and lower expenses. Given the increasing popularity of products like flat-panel televisions, Circuit City's future looked even brighter, and Chuck scooped up some shares.
  • Blockbuster (NYSE:BBI): By 2002, you couldn't say Blockbuster's name without someone suddenly blurting out "Wow, what a difference!" But beyond the catchy jingle, the company had lots more to brag about. Blockbuster was the video rental company, and millions of customers, including Chuck, enjoyed their "Blockbuster nights."

All in all, these seemed like reasonable choices. Here's what went wrong:

Gone in an instant

  • Yahoo!: A few months after Chuck became a proud Yahoo! shareholder, the company's ad revenue began to slump. By the end of 2000, BusinessWeek reported that the company had "fallen through the floor." But there was another problem: Yahoo!'s stock carried an insanely high valuation -- which meant that in order to keep the share price from crashing into oblivion, it had to meet extremely high expectations. It suddenly wasn't, and a shower of analyst downgrades followed. Pepper in some fierce competition from Google (NASDAQ:GOOG), and even today, Yahoo!'s stock trades at a fraction of what it did eight years ago.
  • Circuit City: Circuit City, along with other retailers such as Best Buy (NYSE:BBY), took a beating last Christmas when Wal-Mart (NYSE:WMT) slashed its prices and forced competitors to sell their products at painful discounts. But unlike Best Buy, Circuit City never seemed to recover from the holiday war. It began to shut down stores (red flag No. 1), its CFO jumped ship (red flag No. 2), and then -- get ready -- the company fired 3,400 employees and replaced them with lower-paid workers. When that didn't turn out too well (duh), it asked some of the employees it laid off to come back!

    Add the effects of a tough year for retail in general, and you'll understand why the stock has dropped from $27 to around $7 in one year.
  • Blockbuster: Blockbuster's biggest blow came from changing trends. When Netflix (NASDAQ:NFLX) stepped onto the scene, it transformed the video rental industry. Customers began to flock to the Internet for home-delivery convenience and zero late fees. Blockbuster eventually retaliated by offering similar services, but by then, Netflix had already established a strong brand and a solid customer base. At less than $5 per share, Blockbuster's stock looks like a mere cameo compared to its $30 price five years ago.

Moral of the story
There's nothing wrong with buying large companies that sell popular products, but it's not enough. Among other things, you should also look for:

  • Top-notch management: Management should make smart choices that move the company forward. If the folks in charge start to make ridiculous decisions like Circuit City's, run fast.
  • Keeping up with the Joneses: Make sure the company keeps up with changing trends -- and its competitors. For example, when McDonald's noticed a trend toward healthy eating in the United States (not the best news for a fast-food joint), little time passed before we saw "white meat" Chicken McNuggets, premium salad offerings, and wrap sandwiches -- and shareholders are lovin' it!
  • Reasonable valuations: Again, high valuations aren't necessarily bad. But they give a business lots more to live up to, which increases risk.

Of course, these are just three highlights. If you don't have time to tack down all of the details, the Gardner brothers and their team of analysts can do it for you. Their Motley Fool Stock Advisor service has been beating the pants off the S&P 500 since its inception. You can get a free, 30-day peek at all Stock Advisor recommendations by clicking here. There is no obligation to subscribe.

Cindy Embleton prefers to Google it, just a little bit. At the time of publication, she did not own shares of any companies mentioned. Yahoo!, Netflix, and Best Buy are Stock Advisor recommendations. Wal-Mart and Best Buy are Inside Value recommendations. The Fool's disclosure policy has unerring good sense.