The amazing thing about this market is that there are still so many cheap stocks. The problem with this market is that there are so many companies that could still really blow up.
Your investing success in the next few years to come will be largely determined by your ability to sniff out and avoid the losers. With that in mind, here are some suggestions for stocks you should avoid.
Speculative companies
Right now, 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 the 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.
For instance, a company like Fannie Mae is still trading way off what may be considered a normal price for the stock -- but the stock still isn't cheap. The company is full of all sorts of question marks and black boxes, and it's begging for government assistance. Why would you even consider buying Fannie when you can get a business like Exxon-Mobil (NYSE:XOM) or BP (NYSE:BP) -- both high-quality operations with undoubted staying power -- at just 9 and 7 times forward earnings, respectively? Fannie simply doesn't make any sense.
When even established, well-known companies are seeing strong headwinds, stay away from the companies that aren't well-positioned or that you simply don't understand.
Cash-poor businesses
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 things should give you confidence in a market like this one.
In good times, cash-poor businesses can borrow money or sell equity to tide them over until the business starts producing cash. But in more challenging times, they may only be able to borrow at high rates, sacrificing the long-term cash flows of the company to service the debt. Worse, they may not be able to borrow at all -- and thus be forced into bankruptcy.
It may not even be the result of poor management -- some industries are chronically cash-poor because of their capital-intensive nature. Automobile manufacturers (even "good" ones) like Ford (NYSE:F), for example, often have to spend their cash flow on the next generation of cars just to compete. As a rule, be very cautious of companies that struggle to generate excess cash -- in times like these, your investment may be at risk.
Near-term debt maturities
The credit crisis we're in means lenders are risk-averse and attempting to reduce their leverage. That means that even profitable companies can run into trouble if they have debt maturing that they can't pay off from cash or rollover.
In this instance, I would be very concerned if I held a company like Blockbuster (NYSE:BBI) -- a company that is in a terrible strategic position thanks to Netflix (NASDAQ:NFLX) and other digital players. Worse still is that the company carries a massive debt load relative to its size (a big chunk of which comes due in the next two years), and it doesn't have a whole lot of cash in the bank to work with in the meantime.
Given the tightening of corporate credit across the board, stay away from companies with significant debt coming due anytime 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 (NYSE:WFC). But it will also indirectly affect any company that expects its customers to buy on credit. This ranges from manufacturers like Toyota Motors to big-screen television distributors like Best Buy (NYSE:BBY). If that hybrid car loan is harder to securitize, consumers will be charged higher interest rates, and that will reduce demand in general -- thus reducing demand for all of the parts, supplies, and labor that go into a product.
So you should be cautious of companies with business models that don't work in this environment, one where it's hard to borrow money at reasonable rates, businesses are deleveraging and downsizing, and consumers are scaling back.
The Foolish bottom line
All that being said, don't just blindly avoid any stock that has one of these flaws. Do, however, investigate further. 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 while deciding 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 interests in any company mentioned above. Best Buy is a Motley Fool Inside Value pick. Netflix, Best Buy, and Ford are Stock Advisor recommendations. The Fool owns shares of Best Buy. The Fool's disclosure policy is anything but doomed.
