In this market, wonderfully cheap stocks abound -- but so do far too many companies that could blow up in investors' faces.
Your investing success in the next year will be largely determined by your ability to sniff out and avoid losers. With that in mind, here are some suggestions for stocks you should avoid.
For starters, you should avoid money-losing businesses, companies that need high growth to justify their high earnings multiples, start-up companies that are dependent on the growth of new markets, and other speculative stocks.
Right now, you can find solid blue-chip stocks that are undervalued by unprecedented amounts. If you can buy a stock that should be trading at double or triple its price, why would you want to risk your money on a stock with less probable gains? In such an environment, speculative bets just don't make sense.
General Motors is trading at multidecade lows at present -- but the stock still isn't cheap. The company is projected to lose money as far as the eye can see, and most think bankruptcy is inevitable at the end of the month. Why would you even consider buying GM when you can get Berkshire Hathaway
When even established, well-capitalized companies must endure strong headwinds, you're better off avoiding companies with a less secure foothold in the market.
Sometimes businesses report earnings, but don't produce cash. Sometimes earnings are recognized as an accounting gain immediately, but the cash comes in later. Sometimes capital expenditures can exceed the operating cash flows. None of these should give you confidence in a company, especially in a market like this one.
In good times, cash-poor businesses can borrow money or sell equity to tide them over until they start producing cash. But in more challenging times, they may only be able to borrow at high rates, sacrificing their own long-term cash flows to service the debt. Worse, they may not be able to borrow at all -- and thus be forced into bankruptcy.
This sad fate may not even result from poor management; some industries are chronically cash-poor because of their capital-intensive nature. Consider Host Hotels
Palm, yet another example, has been working on the up and up recently, especially with its new device, the Pre, generating a lot of buzz. But its operations are burning more cash than they're bringing in. Developing a hot new phone (especially one intended to rival the iPhone) costs money, and that's fine. But the lack of free cash flow is nevertheless worrisome in an environment in which cash may not be forthcoming to make up for significant shortfalls. Beware dilution.
Near-term debt maturities
Our current credit crisis means lenders are risk-averse and attempting to reduce their leverage. Thus, even profitable companies can run into trouble if they have debt maturing that they can't either roll over or pay off from their own cash supply.
CBS has considerable hurdles to clear in the near term, with a difficult operating environment and very significant cash obligations in the coming years. If I were a shareholder, I'd be concerned.
Same goes for Sprint Nextel. Though the company is making cash, it carries a whole lotta debt --- some of which comes due fairly soon. This is a troublesome situation, especially since Sprint continues to trail far behind industry leaders AT&T
Given the tightening of corporate credit across the board, I'd urge Fools to stay away from companies with significant debt that's coming due any time soon.
Broken business models
Because credit is the grease of the business world, the credit crisis means the rules of the game have changed. Business strategies that worked two years ago, like depending on borrowed money, are now much less feasible.
Consider securitization, the practice of pooling loans into bond-like securities and selling them to investors. The housing bust has caused the value of mortgage-backed securities to plunge, and other securities have done the same. Consequently, investors are reluctant to buy -- and while these securities are unlikely to go away, they may become more regulated. They'll certainly be much harder to sell, and therefore less profitable, in the future.
It's apparent that this change will directly affect most lenders, from Bank of America to Wells Fargo. But it will also indirectly affect any company that expects its customers to buy on credit. This ranges from car manufacturers like Toyota Motors to student loan processors like First Marblehead
So you should be cautious of companies that have business models that don't work in an environment where it's hard to borrow money at reasonable rates, where businesses are deleveraging and downsizing, and where consumers are scaling back.
The Foolish bottom line
That said, one of these flaws shouldn't blindly scare you away from a stock -- it may just signal that you need to do a bit more investigating. Sometimes the issue will be catastrophic for shareholders, but sometimes it will simply be a small hurdle affecting a fraction of the overall business.
These are just some of the issues we examine at Motley Fool Inside Value, as we decide whether a stock is truly cheap or just a value trap. To see our favorite stocks in this market, take a 30-day guest pass to Inside Value. Click here to get started -- there's no obligation to subscribe.
This article was originally published on Dec. 5, 2008. It has been updated.
Fool contributor Richard Gibbons has no positions in any of the securities mentions. Berkshire Hathaway is a Stock Advisor pick and an Inside Value pick. The Fool owns shares of Berkshire Hathaway. The Fool's disclosure policy is anything but doomed.