How to Spot a Lousy Investment

Readers are a blessing for a writer, especially when they ask important questions. Here's one that reached my inbox not long ago: "How does an inexperienced investor know what to look for?"

A great stock gone bad
The query related to my profile of twentysomething Rob Ketterer, who, through Foolish investing, transformed $500 into a new house. While Rob's story is remarkable, what caught the reader's attention was my failure to profit from Sun Microsystems (NASDAQ:SUNW).

Six years ago I let a 20-bagger slip away by ignoring deteriorating business conditions at Sun. By asking for details, my fellow Fool hoped to learn what warnings signs I had missed and, in turn, improve his own investing. Good idea. Here's my answer, Andy.

Why Sun was a loser
With Sun, there were three important signals:

1. 1999 marked a rare moment when Sun's P/E ratio exceeded both its anticipated earnings growth and the average P/E of the S&P 500.
2. At the same time, Sun's average cost of sales was growing at a faster rate than total sales.
3. Finally, by 2000, Sun had acquired more than $2 billion in new debt after years of subsisting mostly on free cash flow.

In short: Sun's stock was more expensive than it had ever been when management pulled out the corporate credit card to fund new growth.

How to spot a loser
But Sun's sordid tale is one of many:

Stocks that binge on lush promises always get sick when reality bites. Yet, over the short term, Mr. Market can be nuttier than Mr. Peanut dunked in a gallon of Jif.

That's how it was for Ballard Power in 2001. Press reports praised its renewable energy technology. Meanwhile, investors paid as much as $252 per share for every $1 in revenue the company booked. (More on how this works is available in the "price-to-sales" ratio entry in our Foolish Fundamentals series.)

That might have been a reasonable premium if Ballard was also tripling its sales every year. But it wasn't -- Ballard had grown revenue by just 24% in 2000. By the summer of 2001, the stock was in freefall. It has yet to recover.

3 questions for avoiding losers
How can you tell whether you hold the next Ballard Power? Check with Morningstar.com -- it hosts 10 years worth of financial statements and valuation ratios for most firms.

Then, once you've got the data for the stock you're investigating, ask these questions:

1. By historic standards, is my stock trading for more or less than it usually does?
2. If it's more expensive, is there news (i.e., a thriving new business, a big insider stock purchase, etc.) that justifies the premium?
3. If it's cheaper, is there news (i.e., poor results, management turmoil, etc.) that justifies the discount?

This simple exercise will get you thinking like all of the best investors do. When you're ready to learn more, try reading Peter Lynch. His One Up on Wall Street is still my favorite primer for stock-picking greenhorns.

Or, if you'd prefer the shorthand version, test-drive our Motley Fool Green Light personal finance service. Co-advisor Shannon Zimmerman wrote up a summary of Lynch's works in the December/January issue. (Subscribers can click here for direct access.)

Follow the money
Stock picking is an acquired talent that can be had with time and effort. Start by learning to avoid big portfolio mistakes. Then, read up on investing masters like Lynch. Studying their strategies will help you to make the most of your investing dollars. You might even turn $500 into a new house.

But even if you don't, your stock-picking journey will make you richer -- both financially and intellectually -- than you are today. That's an investment any Fool can appreciate.

Fool contributor Tim Beyers writes weekly about personal finance and investing basics. Have a Foolish money tip? Tell him. Tim didn't own shares in any of the companies mentioned in this article at the time of publication. The Motley Fool's disclosure policy puts the green in your wallet, where it belongs.