Separating Deals From Duds: Blindly buying stocks can be hazardous to portfolio

By Katy Marquardt

The ups and downs of the stock market by Mark Weber

A low share price doesn't always indicate a bargain. Often, when a company's shares have fallen off a cliff, so have its earnings.

"There are two kinds of cheap when it comes to stocks: those that deserve to be cheap and those that don't," says Bob Auer, senior portfolio manager of the Growth fund.

"Just because a stock used to be $30 and is now $4 doesn't mean it's a good deal. They're zombie stocks -- the walking dead -- but we haven't killed them off yet. I wouldn't touch these."

So how do you separate the deals from the duds when it comes to picking stocks in a tough market?

If you don't have the time or the know-how required for individual stock investing, it's better to leave it to a professional or put faith in an index.

But if you'd rather be the stock picker, get ready to do some digging -- through annual reports and 10Qs (quarterly updates companies are required to file).

Here are a few tips on how to evaluate stocks, including things to look out for:

Understand why the stock is cheap

Some cheap stocks are actually value traps, which "look cheap, but they aren't really because something is fundamentally wrong with the company," says Tim Hanson, a senior analyst at the Motley Fool.

"These stocks could go down further or won't outperform the market and generally end up being disappointing."

Not only should you look beyond a company's current share price; you should look beyond its past performance, especially in the short term.

For example, a lot of companies that shot out the lights in previous years, Hanson says, but were buoyed by a strong economy and a risk-on stock market.

"You might be wowed that a stock grew 20 percent or 25 percent and think it'll get back there in the futre," he says. "But the company might be a natural grower at 8 percent. You can get blindsided if you don't look further back."

Share prices are a fine place to start, but balance sheets -- which you'll find within each quarterly report -- will give you a better picture of a company's health and growth prospects.

The challenge, of course, is learning how to read balance sheets. Here's a quick primer from the SEC.

Identify Quality Stocks

In shaky markets, quality rules.

That means companies with airtight balance sheets, smart managers, and plenty of cash on hand.

Larry Coats, a manager of the Oak Value fund, says he's looking for businesses that have "a superior position from a competitive standpoint, a superior structure in the way they operate, and no significant debt."

He continues: "There's nothing wrong with buying cheap, but if you buy a lousy business at a cheap price, you've only got one way to be right -- and that's that the stock's cheap."

A good way to get a glimpse of the company's operations -- as well as its management in action -- is by listening to its quarterly earnings call. This teleconference, which is usually broadcast live several hours after the earnings announcement, is your chance to eavesdrop on company bigwigs discussing the quarter's financial results and filling in details not included in the earnings release. Sometimes, individual investors can call in and ask questions at the end. If you miss the whole thing, you can find full transcripts of the calls.

Cash versus debt

Banks are tightening lending these days, which could lead to cash shortages for companies that are overly leveraged.

Investors should look at how much cash a company has on hand (listed under "current assets" on the balance sheet) versus how much debt is on the books (listed under "liabilities").

Generally, you want to see that assets are greater than liabilities by a fair amount.

"Subtract assets from liabilities, and you get net worth -- just like if you subtract your debt from what you have in checking, savings, and so on," says Auer.

But there's more, he adds: "There are current assets and others. Current assets are easy to add up: that's your checking, savings, CDs, and what's in your wallet. 'Others' is open to interpretation -- saying your condo is worth $230,000, for example. You want a company that has a lot of assets under current assets."

Price-to-earnings

A price-to-earnings ratio, which essentially weighs what you pay for a company against what it's earning, has historically been the most popular way to judge a company based on one number. But P/E's don't tell the whole story. (A good rule of thumb is never to consider any one figure or ratio alone.)

"The problem is that your "E" is not always representative of how much you're making because it can be manipulated by accounting," says Hanson.

For example, a company may have shipped products and recorded them as assets under "accounts receivable," even though those products haven't yet sold.

Try this simple detective procedure from Hanson: "Make sure the net earnings they're reporting actually match their cash earnings. If they don't match, a lot of the time it's accounts receivable."

Investors often use P/Es to compare companies and spot bargains.

It's important to keep in mind that P/E ranges sometimes differ from industry to industry in accordance with that industry's growth expectations.

Technology stocks typically have higher P/Es than utilities, for example.

Be sure to compare companies with peers in their industry, and take into account the industry's overall growth prospects.

Another tip:

Auer suggests looking at a company's earnings over the past three years -- as opposed to the past few quarters -- to get a better picture of its profitability.

"Three years takes out the troughs," he says. "And if you're looking for a safety net, see if they were profitable in the past."

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Cheap Stocks: Separating Deals From Duds: Blindly buying stocks can be hazardous to portfolio
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