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 Bare Escentuals (NASDAQ:BARE), a once-hot cosmetics firm that has seen growth slow during the economic downturn. It has a debt-to-capital ratio of 92.8%, and in the past 12 months its earnings per share have dropped 4.8%, a far cry from its previous heady growth. The stock has plunged 57% in the last year; despite investors having recently bid the stock up from its rock-bottom lows, I’m not convinced it's a bargain, considering its heavy debt load and the way squeamish consumers are watching their wallets.

Or what about Cedar Fair (NYSE:FUN)? Its stock has fallen 51% in the past 12 months. The company has a debt-to-capital ratio of 94.2%; call me crazy, but a company with $1.7 billion in debt and just $13.9 million in cash doesn’t sound like fun to me, especially given its position in the consumer leisure sector, a precarious place to be these days.

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. LTM = last 12 months.

These all look like hemlock to me. Windstream may be the exception in this group, having managed to report a profit in the last 12 months, but bear in mind that the earnings per share represent more than a 50% decline from the year before. Meanwhile, it’s got a whopping $5.4 billion in debt -- thanks, but no thanks.

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, Apple (NASDAQ:AAPL), 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 40 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.

Alyce Lomax does not own shares of any of the companies mentioned. Apple is a Motley Fool Stock Advisor pick. Bare Escentuals is a Motley Fool Rule Breakers recommendation. Windstream is a Motley Fool Income Investor pick. The Motley Fool is investors writing for investors.