The Investor's Dreaded Four-Letter Word

Four-letter words usually aren't associated with anything pleasant. The word golf, for instance, tops my list.

The investment field also has a dreaded four-letter word that investors would be far better off avoiding ... now more than ever.

Worse than the "R" word
Mr. Market hates to hear the word recession. But recessions come and go, and nobody can do a thing about them. What's more, not all recessions have been detrimental to stock investors. Those who seek out sound businesses at attractive valuations should be able to weather any storm.

No, the four-letter word I'm talking about is debt.

It isn't bad but can be deadly
When used prudently, debt can be a wise capital allocation tool. Unfortunately, not many managers are effective at both managing and allocating capital. Small doses of debt are fine, but too much debt or leverage can kill you.

Warren Buffett once quipped, "It's only when the tide goes out that you know who's been swimming naked." When the business environment is strong and markets are in an upswing, companies loaded with debt will be fine, because the profits are growing. However, smart investors and Fools know that things don't go up forever. And when the markets correct, as they always do, sloppy companies find themselves naked ... and it's not a pretty sight.

How to find a pretty sight
Instead of continuing to thrash mortgage lenders, Wall Street banks, and homebuilders -- except for NVR (NYSE: NVR), which has little debt -- I think highlighting some good companies with little or no debt would be more useful. Fools should use this list as a starting point for some promising hunting.

*Forward price-to-earnings ratio. 

All aboard the freight car
China's energy needs have caused a surge in demand for coal, and economics tells us that when demand goes up, so does the price, all other things being equal. How fortunate, then, that FrieghtCar's bread and butter are its coal-carrying cars.

Shares in this wonderful little business were trading as low as $29 a few weeks back. That figure included nearly $17 a share in cash. So for essentially $12 a share, an investor was getting a business that had earned $10 a share in 2006 and nearly $4 a share in 2007.

The company does expect slightly lower profits in 2008, but with no debt and trainloads (ahem) of cash, not much needs to happen for patient investors to make money here. In fact, the stock provided another catalyst for value creation recently, when it surged on news of a joint venture with India.

All circuits on
Most retailers are feeling the pain from consumers tightening their wallets. Specialty retailers such as Circuit City are in particular agony because pleasure items such as plasma TVs are often what people avoid buying when they're low on cash. Yet Circuit City has a cushion of more than $2 in net cash and a book value per share of $8.50, all while it trades for less than $5 a share. It might take a while to right the ship, but the company's solid balance sheet gives it the luxury of time.

Absence of debt as margin of safety
Investors take comfort in companies bearing little or no debt. Those companies can use any excess cash to pay a special dividend or prudently buy back stock. Such corporate actions can increase value during weak business conditions, and strong balance sheets bearing little debt are one type of margin of safety.

So when you invest, look for those three words -- margin of safety -- and avoid the dreaded four-letter word of debt.

More value-creating Foolishness:

• 3 Ways to Preserve Capital
• Make Money by Doing Nothing
• The Value of a Franchise