The amazing thing about this market is that there are so many cheap stocks. The problem with this market is that there are so many companies that could really blow up on investors.
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.
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, right now, shares of Bank of America (NYSE: BAC) could plausibly be attractive if you had the ability to be confident in the quality of their books. But you can't. At best, the credit quality of many of Bank of America's loans is uncertain. At worst, these are more financial bombs waiting to go off. Even those employees close to the situation likely have little comprehension of what that bank's most important assets are worth. Why would you even consider buying into a black box when you can get a company like Procter & Gamble (NYSE: PG) -- a terribly high-quality operation with a very strong balance sheet and products that consumers crave -- at just 15 times earnings? Bank of America simply doesn't make sense.
When even established, well-capitalized companies are seeing strong headwinds, stay away from the companies that aren't well-positioned.
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 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. Consider resort businesses like Wynn Resorts (Nasdaq: WYNN) and Las Vegas Sands (NYSE: LVS), for example, that are constantly burning tremendous amounts of cash to build the next big thing.
Las Vegas Sands typically spends billions of dollars on capital expenditures every year to enhance its casinos and hotels (it must to compete). Meanwhile, it only pulls in a few hundred million in operating cash. The disconnect is substantial and affects shareholders directly. Though the differential is not as substantial, the same is pretty much true of Wynn. When you're in the business of building massive, mind-bogglingly expensive structures that can't earn a cent until they're completely finished, you're putting yourself at an automatic disadvantage.
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.
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. Immediately, we can see how this affects banks, like Deutsche Bank (NYSE: DB) and Citigroup (NYSE: C), that orchestrate these underwritings. In 2007, for example, these two firms underwrote more than $1 trillion worth of new securities. This business has quickly evaporated in the aftermath of the financial collapse and continues to be weak.
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 Dec. 5, 2008. It has been updated.
Fool contributor Richard Gibbons has no positions in any of the securities mentioned. Procter & Gamble is an Income Investor recommendation. The Fool owns shares of P&G. The Fool's disclosure policy is anything but doomed.
