Don’t Poison Your Portfolio

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 Rite-Aid (NYSE:RAD), which faces intense competition in the drugstore space. Meanwhile, it has a total debt-to-capital ratio of 85%, and in the last 12 months, it's lost $1.94 per share. The stock has plunged 89% in the last year and it’s in serious penny stock territory -- but that isn't enough to convince me it's a bargain.

Or what about Saks (NYSE:SKS)? Its stock has also fallen 84% in the last 12 months, and at about $2.58 per share, I still don’t consider it cheap; it's got $649 million in debt, and just $20 million in cash. The luxury marketplace is having serious problems in these difficult economic times, and a massive debt load is a real burden when business -- and revenue -- slows considerably.

Sure, there's a chance companies like these can recover. 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.

*All data from Capital IQ, a division of Standard & Poor’s.

These all look like hemlock to me. Qwest may still be profitable, but note that its earnings have fallen a precipitous 65% over the last 12 months. It also has a whopping $13.4 billion in net debt. Hanesbrands is also still profitable, but revenues are dwindling, and the company faces major headwinds due to the weak retail environment.

None of these stocks constitute a gamble I'd personally want to take, especially given their debt loads.

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. One of their recommendations, Netflix (NASDAQ:NFLX), is an example of a company that has cash on the balance sheet, generates free cash flow, and has negligible debt. Tom and David's recommendations overall are beating the S&P 500 on average by 30 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 Motley Fool Stock Advisor recommendation. The Motley Fool is investors writing for investors.