Stop Buying These Stocks

A few weeks ago, my Foolish friends Brian Richards and Tim Hanson profiled five stocks they felt investors should avoid. Their argument struck me as pretty straightforward: Investors would be well-served to avoid companies with opaque financial statements (like Citigroup (NYSE: C)) or complicated government ties (like, um, Citigroup).

Apparently many members of our community disagreed.

Pointing to their significant short-term gains in stocks such as Bank of America (NYSE: BAC) and Ford (NYSE: F), many readers (rather rudely, in my opinion) insisted that Brian and Tim’s analysis was invalid.

This comment from IronBob is a good representation of the feedback that Brian and Tim received:

INCREDIBLE! Thanks for the advice! I'm glad I'm ignoring it as I almost doubled my money on Ford in less than two months!

While I’m happy for IronBob, I’d like to caution readers that his returns are hardly typical -- and that short-term speculating in no-moat companies is simply not a sound investing strategy.

Just say no ... to short-term speculation
Jumping in and out of stocks is certainly exciting, and -- if you're lucky -- it can result in some satisfying short-term profits. But over the long haul, active trading is a loser's game.

For starters, you have to correctly predict both the direction and the timing of a stock's move, which most experts agree is impossible to do with any consistency. Anyone can get lucky once or twice, but repeatedly? Forget it.

And then there are the frictional costs of taxes and trading commissions, which can combine to take a big bite out of your returns.

Plus, there's the unfortunate fact that we humans make for lousy traders. We tend to sense patterns that don't exist, overreact to innocuous stimuli, sell our winners too soon, and hang on to our losers for too long.

In an oft-cited study, professors Brad Barber and Terrance Odean found a strong correlation between active trading tendencies and abysmal stock returns. In other words, the more frequently their subjects traded in and out of stocks, the worse their portfolios performed.

A perfect storm for poor performance
Unfortunately, the current climate has created the ideal scenario for short-term speculation.

Investors of all shapes and sizes have lost a significant amount of money in a relatively short time span. The heightened market volatility has made for some sensational short-term price swings. And the economy appears to be headed down the tubes.

Based on the volume and content of our reader comments and hate mail, it’s clear that these factors have combined to make investors increasingly short-term-oriented and willing to invest in companies with highly uncertain futures. During the market rally over the last month or so, these traits have been rewarded. But if history is any guide, that will not be the case over the long haul.

What this means for you
In other words, if you're interested in preserving your capital and accumulating long-term wealth, stay away from short-term speculation in subpar companies.

Don't buy First Solar (Nasdaq: FSLR) because you're counting on a jolt from President Obama's alternative energy program. This company specializes in an unproven technology that is rapidly evolving, and it has a host of competent competitors. The potential rewards in this space could be vast -- or nonexistent.

Don't buy Bank of America or Citigroup because you heard that banks would benefit from the elimination of mark-to-market accounting. Nobody can say for sure exactly what insidious assets sit on these companies' balance sheets.

Don't buy Sirius XM Radio (Nasdaq: SIRI) because of Liberty Media’s recent capital infusion. This company is anchored to the auto industry, loaded with debt, and always willing to dilute shareholders.

Don't buy Stone Energy because a talking head on TV said that oil can't possibly go any lower. In fact, don't buy a stock based on anything that you hear on TV!

So what should I buy, smart guy?
That's easy. Concentrate on buying great businesses -- companies with straightforward business models, sound balance sheets, strong financial statements, and shareholder-friendly management. If you buy such businesses when they trade at a significant discount to intrinsic value, it's highly likely that you'll make a lot of money over the long term.

Instead of the companies I mentioned earlier, why not buy shares of Marvel Entertainment (NYSE: MVL), your friendly neighborhood comic book company? Its characters are timeless, and its financials are gorgeous, thanks to the high-margin licensing business. Based on the strength of its Spider-Man franchise and a powerful new movie studio segment, Marvel has soared 705% since David Gardner first recommended it to Motley Fool Stock Advisor members back in July 2002.

Or how about Costco Wholesale (Nasdaq: COST)? This membership warehouse retailer has strong recurring revenues, pristine financials, great growth potential, and perhaps the most shareholder-friendly CEO around in Jim Sinegal. This great business has always traded at a premium price, but today, it trades at its cheapest level in years. This stock is up only 25% from where Tom Gardner recommended it way back in May 2002 -- but that sure beats the negative 23% return for the S&P 500 over the same time period!

To read more about Marvel, Costco, and the rest of David and Tom's top selections, click here to take a free 30-day trial of Stock Advisor. As always, there is no obligation to subscribe.

Already subscribed to Stock Advisor? Log in at the top of this page.

Rich Greifner would happily buy shares of Costco if he could ever stop writing about it. Stupid Foolish disclosure policy. Costco and Marvel are Motley Fool Stock Advisor recommendations. Costco is also an Inside Value pick. The Motley Fool owns shares of Costco.