6 signs of stocks to avoid

Peter Lynch could be called a contrarian investor in many senses, and it is with good reason: so-called hot industries and hot companies are driven up by EMOTION (I consider social pressure an "emotion" here, as "need to conform"). Once the emotion is spent, the company fizzles, and stock price nosedives so fast and so far it'll give you a nosebleed.

Advice 1) AVOID the hottest company in the hottest industry

Why? three main reasons:

a) hottest company have stock prices inflated by speculators, which in turn attracts MORE speculators, which fuels even FURTHER price inflation, until it all inevitably comes back down.
b) Hot industry attracts competitors, unless you got an exclusive niche you can exploit. Xerox was so famous, their name is synonymous with "photocopy". However, when IBM, Kodak, and various Japanese companis got into the copy machine business, Xerox stock prices tumbled, and never really recovered.
c) trend comes and goes, and so do fortunes of the trend-riders. 20 years ago carpet was the hottest thing. Now wood flooring is preferred. When will it switch back to carpet? (Robert Kiyosaki called it "flavor of the month" in Rich Dad's Guide to Investing, I think it was)



Advice 2) AVOID "the next ________"

Promoters will try to explain that this new company is the next _______, and name a hot company. That is usually a bad sign, because a) it is in a hot industry, and b) it is competing against someone else already more established. While this company may have the better product, the risk is tremendous as you can't predict how the market fight will turn out.

When Circuit City stores launched to their success, clones started appearing. Highland, Good Guys, Crazy Eddie... except they all died, and later, so did Circuit City (as a brick-and-mortar retail shop). Most clones are just that: clones, and not as good as the original, unless they truly are different. And if they are different, why would they be described as "the next ________"?

Advice 3) AVOID "di-worse-fications"

Some corporations, flush with cash due to several years of good earnings, instead of helping stockholders by either stock buyback or dividends, decided to go on an acquisition spree, and often in unrelated fields (to their own core business). This is a very bad sign, esp. if they are jumping into unknown territory. Why? a) acquisition usually means paying ABOVE market price, and b) being unfamiliar with the new firm is bad for business. As a result, BOTH companies lose money, and may never rebound. In a few years, the parent company announced a restructuring, and sell off the acquisition at a low price.

The only ones who really gain from di-worse-fications would be the stockholders of that smaller company being acquired. The company selling may be worth checking for turnaround potential, as is the smaller company being divested. It may be also worth an asset play.

So how do you tell good acquisitions vs. di-worse-fications? Look for synergy between the acquirer, and the acquiree. Say, a hotel chain buys a restaurant chain, or restaurant supply chain, that would sort of makes sense, as hotel needs a lot of food and food-related equipment. There is synergy there. However, there would be no synergy if a hotel chain buys an auto parts store chain.

What if the acquiree is some sort of a conglomerate that has a bit of everything? A proper acquisition would acquire the parent, then quickly sell off or spin off the parts that the acquirer doesn't need. If it doesn't, the acquirer's stock should be avoided, as it's clear the management doesn't have a plan or clue.

Advice 4) AVOID "the whisper stock"

The "whisper stock" is something recommended with a whisper, as in "come here... closer. This one looks really good, but it's a longshot... I am telling you this because I value you as a friend..." kind of a whisper. In other words, it's a super-longshot. It is probably a small/tiny company, working on something exotic, but definitely "new and exciting". Could be working on something that may solve some sort of a major problem, like diabetes, oil and alternative energy, jungle remedy (it was noni juice, then mangostreen juice, now acai berries...), some sort of miracle additive that'll revolutionize SOMETHING... Basically, the solution they offer are a) very imaginative, very exotic, or b) impressively complicated techno-jargon-y.

Whisper stocks have an emotional appeal because they look good, at least upon initial glance. They appeal to your "cheer the underdog" instincts, as well as appeal to your greed ("this may be the homerun!"), and even the feel good side (I may be helping saving ______!) The problem is, they, almost without exception, die on the vine, because they have no fundamentals to back up the company. They do the razzle dazzle with some slick presentations, some Ph. D.s talking, some impressive looking labs and whatnot, some high hopes, and some cash from the stock offering, hoping to get some big names attached to the project. There would be no earnings until something useful comes out of that lab, and the rest, well, is mostly smoke and mirrors. Usually such stocks stay worthless and simply folds when it runs out of capital.

Beware of IPO mania, which is a subset of this problem. A lot of the exciting IPOs have speculators drive up the prices multi-fold the first day, making them way too inflated to be worthwhile, unless you were able to buy in at the IPO price, then sell it the same day and cash in the profit. Way too risky, unless you have a huge portfolio to cushion you if you mess up. Lynch recommends you should only buy IPOs of companies that were already in business, either as a private company, or got spun off an existing company, and thus, already have an operating record.

Advice 5) AVOID "one-client" companies

If the company makes stuff, and only one (or a few) clients buy them, then the company is in tremendous risk. That client has enormous leverage over the company to extract price concessions, payment terms, and other stuff... even MORE so if that company has competitors.

Just to give a theoretical example... Let's say, uh... Western Digital, who makes hard drives, currently only sells to Dell Computers (in reality, Western Digital sells retail, wholesale, OEM... all of it). If Dell says "we're a little tight on cash. You'll get paid in 30 days instead of Cash-on-delivery", what is WD going to do? What if Dell says "lower your prices another 10% or we'll switch to Seagate (another computer hard drive maker)"? Or worse, "we don't need you any more. We decided to make hard drives ourselves." (as I said, it's just an theoretical example to illustrate the point)

Such companies, no matter how successful, should be avoided. You never know what their clients may do... especially when some sort of a market pressure, such as bad economy, heavy competition, and so on, starts to show.

Advice 6) AVOID the "trendy name" companies

UAL, parent corporation of United Airlines, changed its name to Allegis, as apparently UAL sounded too dull.

A lot of people, believe it or not, decide to invest in a company because it sounded good. That is simply illogical, but it's true. If the company name has "tron" or "tech" or some nonsense made-up name that sounded good, it may get investment whereas an incredibly dull name like "Crown, Cork, and Seal" or "Seven Oaks International" would not.

So you should do the exact opposite, if only to avoid the mob effect.