FOOL ON THE HILL
Stocks to Avoid
What sort of companies is Whitney Tilson careful to avoid? In this article, he discusses three: money-losers that might be headed to zero, speculative companies with extreme valuations, and weakening blue chips
By Whitney Tilson
January 16, 2001
While most investors focus their energies on picking stocks that they hope will be big winners, an equally important part of successful long-term investing is being aware of -- and avoiding -- dangerous stocks and investment strategies. As Warren Buffett wrote in his 1996 annual letter to shareholders:
"We try to 'reverse engineer' our future at Berkshire (NYSE: BRK.A), bearing in mind... [the] dictum: 'All I want to know is where I'm going to die so I'll never go there.' (Inverting really works: Try singing country western songs backwards and you will quickly regain your house, your car and your wife.) If we can't tolerate a possible consequence, remote though it may be, we steer clear of planting its seeds. That is why we don't borrow big amounts and why we make sure that our [super-catastrophe insurance] business losses, large though the maximums may sound, will not put a major dent in Berkshire's intrinsic value."
With this in mind, I'd like to highlight three types of stocks that I almost always avoid:
Weak, money-losing companies, generally with stocks below $5, in which bankruptcy is a real possibility.
Speculative, money-losing companies that have extreme valuations, often due to excitement over some type of emerging technology. In particular, beware of third- or fourth-tier "me-too" companies.
Blue-chip companies that are showing clear signs of weakness (especially on the balance sheet and cash flow statement) but retain high valuations due to their image as stalwarts -- and, in many cases, accounting tricks that maintain the illusion of strength.
If you disagree with my assessments of some of the stocks I mention in this column, that's fine -- maybe I'll be wrong -- but don't send me emails accusing me of trying to drive a stock down for my own gain. I don't short stocks.
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Speculative, money-losing companies with extreme valuations
It's human nature to be attracted to exciting new technologies, but I would argue that it's generally unwise for the average person to invest in early stage companies -- especially at high valuations -- that do not have proven technologies or business models, much less profits or even revenues. This type of investing was once left to experts, such as venture capitalists, who could properly evaluate the many risks and, equally importantly, invest at low valuations.
But in recent years, the bull market attracted a flood of gullible (and perhaps greedy) first-time investors who were willing to speculate in such stocks. Not surprisingly, investment banks shamelessly eliminated even the most basic standards and flooded the market with IPOs for companies that had no business going public (or, in some cases, existing at all). Some of these companies, like Pets.com, went bankrupt the same year in which they went public. Others, like Corvis (Nasdaq: CORV), had no revenues. Unbelievable.
The next time you're tempted to invest in this type of company, consider that Buffett has built the greatest investment track record in history over the past half century without ever investing in such stocks.
Among companies that retain rich valuations, my least favorite companies include Manugistics (Nasdaq: MANU) -- which I have written about elsewhere; see my website (http://www.tilsonfunds.com/) for links -- Active Power (Nasdaq: ACPW) and, though profitable, Krispy Kreme (Nasdaq: KREM). The combination of investors' perception that this could be another Starbucks (Nasdaq: SBUX) and a limited float (soon to nearly triple due to a secondary offering and an ending of restrictions on insiders' ability to sell) caused Krispy Kreme's stock to soar from its $21 IPO price last April to a high last November of $108.50. It closed Friday at $67.31, equal to a rich 74x trailing EPS.
I believe the analogy with Starbucks is faulty. After water, coffee is the most-consumed beverage in the world and is addictive. Doughnuts are, well, doughnuts. Also, Starbucks faced little competition, whereas Krispy Kreme, with 181 stores today, faces many competitors, including Dunkin' Donuts, which has nearly 5,000 stores in 41 countries.
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complete article at: quicken.com
Interesting that Whitney picks on KREM out of all overvalued stocks, especially since it doesn't meet his criteria listed at the beginning of the article. But I believe him when he says he doesn't short stocks. I wonder if his friends do?
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