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Don't Poison Your Portfolio

By Alyce Lomax - Updated Nov 11, 2016 at 4:50PM

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Don't wait till it's too late to wonder about that aftertaste.

Most of us wouldn't knowingly ingest poison and expect a positive outcome. I mean, come on -- it's poison. That stuff'll kill you, right?

So I have to wonder why so many investors gravitate toward poisonous stocks. Cheap or not, those stocks will kill your portfolio -- and when there are plenty of good stocks to choose from, it makes even less sense.

Of course, these stocks don't come with "Mr. Yuck" stickers or more to-the-point skull and crossbones symbols to warn investors of their toxicity. But there are two warning signs that, especially in the current environment, you'd do well to heed.

Toxic business
If a company's business is in the toilet and seeing no immediate signs of recovery, that's a sign to stay away -- even if it looks cheap, and even if it is likely to recover one day.

Take Borders Group (NYSE:BGP), which is struggling with a tough economy, a skittish consumer, and an intensely competitive industry even in good times.

Meanwhile, Borders has a total debt-to-equity ratio of 68.4%, and in the last 12 months, it's lost $2.41 per share. The stock has plunged 95% in the last year and trades at less than a buck, but that isn't enough to convince me that it is a bargain.

Or what about General Motors (NYSE:GM)? Its stock has fallen 83% this year, and at around $4.20, it's still not cheap. It's no secret that the Big 3 have been making some seriously bad business decisions, and, as a consequence, GM has been blowing through its available cash, piling on the debt, and is facing near-term liquidity issues that have made the controversial automaker bailout even more urgent.

Sure, there's a chance companies like these could come back at some point. But as noted value investor Seth Klarman recently said, at some point being too early becomes indistinguishable from being wrong -- and I don't see any reason for investors to even try to take that gamble.

Toxic debt
One of the most poisonous attributes I can think of is a high level of debt -- especially given the current credit crisis. Match that with flagging profitability (or even net losses) and declining or anemic business and you may have a toxic combination on your hands.

For example, let's take a look at a few companies with high debt-to-capital ratios.

Company

Earnings (Loss) per share (LTM)

Revenue growth (LTM)

Total debt-to-capital ratio

Cash

Sirius XM (NASDAQ:SIRI)

($3.00)

49.2%

99.5%

$365.5M

US Airways (NYSE:LCC)

($18.46)

3.6%

99.5%

$1.28B

Avis Budget Group (NYSE:CAR)

($20.01)

3.2%

95.8%

$374M

Reddy Ice Holdings (NYSE:FRZ)

($5.34)

0.5%

96.7%

$33.9M

*All data from Capital IQ and Yahoo! Finance as of Dec. 10, 2008.

These all look like hemlock to me. None of these have managed to be profitable in the last 12 months (and, although Reddy Ice's loss was largely because of goodwill impairments, that stock appears to be in danger of being delisted). Sirius XM is the only one of our contenders that has been able to manage robust sales growth, but clearly it still can't manage profitability and has far too much debt not to be poisonous.

US Airways may not be a surprise given its industry, but still, its metrics are hardly healthy, even if it does have the highest stockpile of cash on the list. None of these stocks constitute a gamble I'd personally want to take.

After all, financing is harder to come by these days, and interest rates choke the monies that companies bring in no matter what the macroeconomic climate. With consumers feeling strapped, many companies will also see less money coming in -- and that's a recipe with a bad aftertaste.

Stocks for a healthy portfolio
There's absolutely no reason to take undue risks on such possibly toxic stocks -- especially when opportunities abound to buy strong, superior companies for the long haul. This bear market has reduced the price of any number of profitable companies with great brands and little or no debt on their balance sheets. Those are the kinds of stocks that will keep your portfolio healthy over the long term.

Tom and David Gardner have long focused on finding wholesome stock ideas for Motley Fool Stock Advisor. Recommendation Netflix (NASDAQ:NFLX) is an example of a company that has cash on the balance sheet, generates free cash flow, and has no debt. Their recommendations overall are beating the S&P 500 on average by 27 percentage points. Why play around with poison when you can get a 30-day free trial to all of the Gardners' best bets for new money now? Just click here to get started -- there's no obligation to subscribe.

This article was first published Nov. 8, 2008. It has been updated.

Alyce Lomax does not own shares of any of the companies mentioned. Netflix is a Stock Advisor recommendation. Borders Group is a former Motley Fool Inside Value pick. The Fool has a disclosure policy.

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Stocks Mentioned

Sirius XM Holdings Inc. Stock Quote
Sirius XM Holdings Inc.
SIRI
$6.79 (1.12%) $0.07
Netflix, Inc. Stock Quote
Netflix, Inc.
NFLX
$242.95 (5.66%) $13.01
General Motors Company Stock Quote
General Motors Company
GM
$37.95 (3.62%) $1.32
Borders Group, Inc. Stock Quote
Borders Group, Inc.
BGPIQ

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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