Avoid These Awful Stocks in 2008

There are two types of stocks to avoid in 2008 -- the ones that are expensive and the ones that look cheap.

The expensive stocks are in a hot sector, one with the potential to change the world. Yet these stocks are among the worst investments I've seen recently. The cheap stocks would be great investments if they survive the next few years ... but some of them won't.

A tough business
The hot sector is solar power. It's a huge growth industry, now that the world is starting to move away from oil and focus on sustainable sources of energy.

The problem is that while the sector is hot, it's unclear how well investors will do. The semiconductor business is a tough one. It tends to be very competitive and difficult to earn high returns. It requires high capital expenditures.

As a result, cash generated from operations -- that could, in other industries, go to shareholders -- will end up buying the next generation of manufacturing equipment. Moreover, this new equipment won't provide any sustainable competitive advantage. Instead, it's what these companies require to stay competitive at all.

What's more, solar panels are becoming a commodity. Sure, there's an advantage to having more efficient panels and more efficient manufacturing processes, but not nearly the competitive advantage that Intel (Nasdaq: INTC) gets from its proprietary processors. So, it's not surprising that there's a lot of competition in the sector.

What's more, if you exclude government subsidies, the economics of solar power are currently marginal at best -- other forms of power generation are generally cheaper. Consequently, investments in this sector carry political risk -- one of the most unpredictable risks of all.

Scary because they're so expensive
So, solar isn't a great business. Yet these stocks are extremely expensive:

Even if everything goes right for First Solar, how well will investors do? Well, the most successful semiconductor manufacturer on the planet is Intel. It's pretty hard to imagine First Solar doing better than Intel.

That allows us to create a (very) rough estimate of First Solar's potential. Intel recently had a market cap of about $165 billion. If everything goes right, and First Solar becomes a huge winner (and doesn't dilute shareholders through management stock options and stock offerings), then the absolute upside is a 700% return. That's not a great return for a growth stock in a crowded market where everything must go as well as it possibly can.

If you must play solar, one way is through Applied Materials (Nasdaq: AMAT), which makes solar panel manufacturing equipment. It's already proven itself in a tough market by becoming the leading provider of semiconductor manufacturing equipment. A significant chunk of the capital being thrown at the solar power gold rush should fall at the feet of Applied Materials, one company supplying "picks and shovels." And there's less risk, since Applied Materials isn't wholly dependent on solar and is trading at a reasonable 15 times earnings.

Scary because they're so cheap
The other group of companies to avoid are the companies that look cheap right now but actually aren't -- companies with significant exposure to the housing bust and credit crunch.

The housing bust is likely to continue in 2008, as tightening credit slows economic growth and hinders access to mortgages. Even companies such as MBIA (NYSE: MBI) and Washington Mutual (NYSE: WM), which seemed indomitable a year ago, look extremely, um, domitable now.

In other words, now is not the time to go bottom-fishing among the weaker homebuilders, lenders, and bond insurers ... even if some of these stocks look really, really cheap. Liquidity and balance sheet strength are critical when it comes to surviving the current environment, and companies that don't have it are likely to fail or require new capital at onerous terms, diluting existing shareholders.

Yes, this crisis will offer opportunities. But investors should do well waiting for more transparency and focusing on businesses that can survive for several years without new capital infusions.

The Foolish bottom line
2008 is likely to be a volatile year. Avoid these two types of high-risk stocks, but keep your eyes open, because that volatility will also bring big opportunities.

In fact, it already has. There are some excellent stocks that are already trading at prices way below their fair value, offering huge upside potential with reduced risk. If you're interested in boosting your portfolio in 2008, our Inside Value newsletter focuses exclusively on these opportunities. You can check out all our recommendations with a free trial.

Fool contributor Richard Gibbons recently got run over by a reindeer. He does not have a position in any of the stocks discussed above. Intel is a Motley Fool Inside Value pick. Suntech Power is a Motley Fool Rule Breakers recommendation. Washington Mutual is an Income Investor pick. The Fool disclosure policy is vibrant, despite the cold.