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 this environment, you'd do well to heed.

Toxic business
If a company's business is in the toilet and showing 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 MGM Mirage (NYSE:MGM), one of many casino industry stocks that have been having a heck of a time lately. It has a total debt-to-capital ratio of 77.2%, and in the past 12 months it has lost a whopping $3.06 per share. The stock has plunged 88% in the last year -- but that isn't enough to convince me that it's a bargain.

Or what about Blockbuster (NYSE:BBI)? Its stock has fallen 72% in the past 12 months, but even though it's in penny-stock territory, I wouldn't consider it cheap. The company has a debt-to-capital ratio of 79%, and Standard & Poor's recently cut its credit rating further into junk territory.

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, and Yahoo! Finance as of April 14.

These all look like hemlock to me; none of them have been profitable in the last 12 months, and Delta's and Hovnanian's losses are steep indeed. General Growth Properties is teetering close to bankruptcy, and several of its bondholders recently threatened to sue the company.

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, Activision Blizzard (NASDAQ:ATVI), is an example of a company that has cash on the balance sheet, generates free cash flow, and has no debt. Tom and David's recommendations overall are beating the S&P 500 on average by 36 percentage points. Why play around with poison when you can get a 30-day free trial of 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.

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Alyce Lomax does not own shares of any of the companies mentioned. Activision Blizzard is a Motley Fool Stock Advisor pick. The Motley Fool is investors writing for investors.