It's undoubtedly been difficult for many individual investors to avoid the temptation to snap up shares of well-known companies now trading in the penny stock range. If you're one of them, I implore you: Don't give in without doing your homework. Most of those beaten-down stocks are in the dumps for good reason.
Despite a few signs of improvement, the macroeconomic climate has been brutal. Many consumers had too much debt. So did many companies. As a result, many companies will be blown right out of the water by the resulting massive deleveraging.
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. All of which makes for one seriously ugly domino effect.
Going, going, gone?
Last year, many people made wild bets on financial stocks like Fannie Mae, Freddie Mac, and Merrill Lynch. I'd guess that many of these folks unwisely ignored those companies' balance sheets, which are more important than ever in these troubled times.
The folly of shoddy due diligence has become evident in the increasing numbers of companies 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 with the Securities and Exchange Commission. Usually, there will be a paragraph with language about factors that "raise substantial doubt as to our ability to continue as a going concern." Need a well-publicized recent example of a company where increasing financial difficulties made people wonder about its ability to continue as a "going concern"? Look no further than CIT Group.
When companies find it increasingly difficult to make ends meet, have negative cash flow, or can't find anybody to lend them money, auditors often eventually question their abilities to stay upright and in one piece. As you can imagine, such questions are popping up a lot more often 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 faces some serious issues.
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, overindebted companies simply won't be able to survive.
Go for the gold, not for the goners
But plenty of stocks out there do represent strong companies with good management and little or no debt -- the kind of companies 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 42 percentage points on average, seeks only the highest-quality companies. For example, newsletter recommendation Amazon.com
Of course, as is always the case with investing, Amazon.com is not risk-free. Consumers could curtail their budgets and limit their online shopping. The company also currently sports a very high price-to-earnings ratio, and it must deal with competition from many quarters. However, Amazon's history of innovative excellence, and its plush cash position, vastly increase its odds of long-term survival. It's a good example of the kind of quality stocks investors should search for.
However tempting the smorgasbord of beaten-down stocks may appear, let's all try to avoid too much speculative bravado. 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.
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This article was originally published on May 12, 2009. It has been updated.