Stocks That Can Burn You

By Sham Gad | October 12, 2009 AAA

Despite what share prices have been doing lately, investors should always be mindful of the downside risk before purchasing any shares of stock. During market rallies, rising stock prices can often mask a flaw in the fundamentals of a business. Investors sleeping at the wheel can pay a dear and expensive price.

IN PICTURES: Eight Ways To Survive A Market Downturn

Don't Get Suckered
A lot of buzz has been afforded the solar power industry over the past few years. While using more and more solar power is definitely a plus for the environment, the share prices of popular names in the space have been propelled more by the dream of an immediate widespread use in solar power versus the actual rate of penetration that we actually have. (For a quick refresher, check out Spotlight On The Solar Industry.)

At $156 a share, the market is pricing an awful lot of future expectations in First Solar (Nasdaq:FSLR). Trading at over 20-times earnings and nearly eight-times sales, there is absolutely no margin of safety in this stock. On top of that you are paying more than five-times book value to participate in the solar play. Yes, the revenues are growing at a high rate, but your paying $13 billion for a company that does about $2 billion in annual revenues. (For related reading, check out The 3 Most Timeless Investment Principles.)

On the other hand, companies like LDK Solar (NYSE:LDK) have tons of debt and are losing money. Because the solar industry is still in relative infancy with respect to is mainstream use, most solar companies continue to rely on government subsidies and other initiatives to hang around, not necessarily the lifelines you want a business to have.

Not This Cup of Joe
Even more mainstream companies can cause investors more harm than good. Starbucks (Nasdaq:SBUX) is going to have a tough time going forward. Selling $4 cups of coffee is not really the business you want to be in right now. To be sure, Starbucks is introducing more budget-friendly coffee choices; nonetheless, the business still needs to sell its popular and pricey coffees. Starbucks earned over $670 million in profit in 2007; for the first half of 2009, Starbucks has earned about $175 million. The company may not earn more than $300 million for the whole year and consumers are really just now embracing frugality.

Not to mention, McDonalds (NYSE:MCD) is expanding the quality and variety of its coffee offerings with great success thus far. And with McDonald's located on just about every suburban block that a Starbucks is, that a serious long-term threat.

The Bottom Line
There are just some business today that, despite the temptation, may offer investors more harm than good. The rising market tide lifts all stocks, but when the tide breaks, the comedown can be painful for businesses and industries without any competitive moats. (For related reading, check out Take On Risk With A Margin Of Safety.)

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