I have a feeling it's been terribly difficult for many individual investors to avoid the temptation to snap up shares of well-known companies that are trading in penny stock range. If you're one of them, I implore you: Don't give in to that temptation without doing your homework, and sometimes even admitting that you're taking a gamble. Most of those beaten-down stocks are beaten down for a darn good reason.
The macroeconomic climate right now is brutal. Massive deleveraging is nothing to mess around with. Many companies will be blown right out of the water. Not only did many consumers have too much debt, but many companies did, too. It's a terrible brew of nastiness.
And now that consumers are dealing with plunging asset values, untenable debt, and increasing job losses, many companies' sales are understandably pinched, making it more difficult to service their own debt or borrow more to fund their operations. It's a domino effect, and it's ugly.
Going, going, gone?
Last year, many people made wild bets on financial stocks like Fannie Mae, Freddie Mac, and Merrill Lynch. I'd venture to guess many of these folks blew off the importance of balance sheets, which are more important than ever in these troubled times.
Meanwhile, the continuing drumbeat of balance sheet pain is being illustrated in the increasing numbers of companies that are disclosing "going concern" warnings from their auditors. You can find those warnings in a company's quarterly (10-Q) or annual (10-K or 20-F) filings. Usually there will be a paragraph with language about factors that "raise substantial doubt as to our ability to continue as a going concern." One of the most well-publicized recent examples of such a company that raised substantial doubt about its ongoing viability was General Motors
When companies find it increasingly difficult to make ends meet, have negative cash flow, or can't find anybody to lend them money, auditors eventually question their abilities to continue as "going concerns." You can imagine those traits are increasing these days.
Accountants are usually reluctant to issue such warnings. According to a recent survey, only about half of companies that filed for bankruptcy in 2001 had actually received "going concern" warnings, so you can bet that when a company does receive one, accountants believe it has some serious issues to contend with.
The proliferation of these warnings should lead investors to think twice about the beleaguered, supposedly "cheap" stocks they're choosing for their portfolios. There could be more spectacular flameouts on the way. The U.S economy -- and consumer -- is in bad shape, and many struggling, over-indebted companies are simply not going to be able to survive.
Go for the gold, not for the goners
But there are plenty of beaten-down stocks out there that represent strong companies with good managements and little or no debt -- the kind of companies that are positioned to survive macroeconomic hardship while beleaguered rivals get taken out.
The team at Motley Fool Stock Advisor, which is beating the S&P by more than 40 percentage points, seeks out only high-quality companies. For example, newsletter recommendation Apple
Of course, as is always the case with investing, Apple is not risk free. It wouldn't be surprising if many consumers eschewed Apple's pricy products in these downer times, and if economic malaise continues for too long, that could be a problem down the road. However, Apple is very well positioned in the survivalist camp of companies because of its history of innovative excellence, plenty of cash, and no debt. It's a good example of the kind of quality stocks investors should search for.
It takes a certain amount of bravery to invest these days, but let's all try to avoid too much speculative bravado, even though those beaten-down stocks may look tempting. Go for the gold, not the goners. If you're looking for more stock ideas, you can click here to read more about the Stock Advisor team's favorite picks, free for the next 30 days.