Last year, it was undoubtedly difficult for many individual investors to avoid the temptation to snap up shares of well-known companies trading in the penny stock range. Now as well as then, investors should never give in to such temptations without doing their homework. Most beaten-down stocks are in the dumps for good reason.
Despite a few signs of improvement, the macroeconomic climate remains brutal. Many consumers had too much debt. So did many companies -- leaving them poised for a pummeling when the resulting massive wave of deleveraging hits.
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 for them 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. Indeed, these investors are still making wild bets; AIG was a very popular stock for speculators for a while there, with a surging stock price despite its high-profile troubles and reliance on government support.
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, you'll find a paragraph with language about factors that "raise substantial doubt as to our ability to continue as a going concern."
Cause for concern
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.
A few companies that have received such warnings recently include Rainier Pacific
What about the company Film Department, which plans an initial public offering in the next month or so? Its financial condition is so precarious that its IPO filing legalese already discloses, "There is substantial doubt about our ability to continue as a going concern." Individual investors, beware.
Other well-known companies have also left folks speculating about their ability to keep on truckin'. Consider Zale
Companies can and do take actions to fix these problems, including amending credit agreements. Still, when a company receives such a warning, investors should take that dire sign seriously.
Alas, accountants are usually reluctant to raise such red flags. According to a recent survey, only about half of companies that filed for bankruptcy in 2001 had actually received "going concern" warnings, and some companies that didn't actually ended up bankrupt anyway. A recent study by Duff & Phelps brought up that problem, noting that rapidly changing factors can make a company's ultimate fate hard to prognosticate.
Still, the proliferation of these warnings, and the reasons why companies fail -- including such obvious flaws such as lack of profitability and too much debt -- 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. Both the U.S economy and the average consumer are in bad shape, and many struggling, overindebted companies simply won't be able to survive.
There are better places for your money
But plenty of stocks do represent strong companies with worthy management and little or no debt. These companies are positioned to survive macroeconomic hardship even as their beleaguered rivals get taken out.
The team at Motley Fool Stock Advisor, which is beating the S&P by 48 percentage points on average, seeks only the highest-quality companies. Consider newsletter recommendations Costco
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.
This article was originally published on May 12, 2009. It has been updated.
Alyce Lomax does not own shares of any of the companies mentioned. The Fool has a disclosure policy. Costco is a Motley Fool Inside Value recommendation. Activision Blizzard and Costco are Stock Advisor picks. Motley Fool Options has recommended a synthetic long position on Activision Blizzard. The Fool owns shares of Activision Blizzard and Costco.