By Dan Ferris, editor, Extreme Value

Friday, June 3, 2016

It's the No. 1 lesson that will make you a superior investor...

Not losing money in stocks is more important than making it.

You can't compound dollars that have died and gone to money heaven.

It always feels like there's something new to buy in the stock market. Humans have a bias toward action. Doing something generally feels better than doing nothing.

Trouble is, doing nothing is the right thing to do in the stock market most of the time.

That's why today, I'm going to share with you the five main types of stocks you must avoid...

1) Expensive stocks

Most higher-quality businesses are too expensive today. S&P 500 companies aren't doing very well these days... So they play games with how they report earnings expectations. Hedge-fund manager David Einhorn says in his latest investor letter that S&P 500 earnings aren't as wonderful as companies reporting higher-than-expected results would have you believe...

In 2015, the S&P 500 companies collectively earned $117, which was 6% less than expected at the beginning of the year. Yet each quarter when companies reported, earnings were about 3% higher than expected, with roughly two-thirds of the companies exceeding estimates...

2016 looks to be more of the same. Since the beginning of the year, bottom-up consensus estimates for S&P 500 earnings have fallen from $126 to $120. Companies are again poised to succeed at clearing a continually falling bar.

2) Busted growth stories in tough industries

The restaurant business is among the worst for investors. It's a tough industry... Most restaurants fail. Look at sports bar and grill Buffalo Wild Wings (BWLD), for example – it's trading for a steep 20 times earnings. It suffers from falling same-store sales growth and a share price to match.

Most oil and gas stocks became busted growth stories when oil prices started plummeting two years ago. They were leveraged bets on high oil and gas prices, and the businesses simply don't work at today's prices. Many will still go bankrupt.

3) Financial engineering schemes running out of steam

When interest rates are low, financial engineering runs amok. Low debt costs become irresistible. Companies borrow larger sums than they otherwise would have to buy their own stock and other companies.

There are three primary types of financial engineering...

•	Rollups. A rollup is when one company buys up a lot of smaller companies in one industry.

	Valeant Pharmaceuticals (VRX) is an example of a busted biotech rollup. But rollups aren't all bad... Successful Kraft Heinz Company (KHC) started out as a rollup in the dairy industry.

•	Share repurchases. It's easy to create shareholder value by buying back the cheap stock of a good business. It's just as easy to destroy it by buying back expensive stock... which is what most companies do most of the time.

	IBM (IBM) is a classic example of a flagging financial engineer. It's buying back far fewer shares these days than in previous years as free cash flow deteriorates. That makes it harder to hide poor results and the overall shrinking of the business.

•	Spinoffs. A spinoff is when a large company distributes shares of a subsidiary to its shareholders, creating a separate public company. Buying spinoffs can be a good idea if you've carefully vetted the company.

	But you must be careful. Not all spinoffs are so great. Many times, a company will spin off a distressed or otherwise-undesirable business, sometimes loading it up with debt in the process. Chemical company Chemours (CC) fit that description when it was spun off from conglomerate DuPont (DD) last year. It spun off at $21 per share and bottomed out around $3 per share earlier this year.

4) The end of speculative manias

A speculative mania occurs when a group of stocks rises dramatically in price, usually to stratospheric valuations, based on the perceived novelty of the stocks. The Internet boom of the late 1990s is a perfect example. Fraud runs rampant during speculative manias and tends to come to light when the mania ends.

The "FANG" stocks – Facebook (FB), Amazon (AMZN), Netflix (NFLX), and Google (GOOG) – are popular with everyone from hedge-fund managers to individual investors. They're trading at absurdly high valuations... No matter what the business, numbers like these in companies this big are historically red flags.

5) Cheap garbage

This generally refers to stocks below $1 per share. The sub-$1 world is where failed public companies go to die, sometimes lingering on in obscurity for years. If you find leveraged oil and gas companies down there, run away with your hand on your wallet. The low share price is both a sign of extreme financial distress and a huge impediment to restructuring distressed loans.

The share price is essentially the market's recognition that the cash will likely burn up and shareholder value will be destroyed. That's not always the case... but that should be your working assumption until you find out otherwise.

No one knows exactly what the stock market will do tomorrow, or which stocks you should purchase for guaranteed gains.

But a smart investor must be aware of what kinds of stocks he should avoid. Sometimes the best move in the market is the one you don't make.

Good investing,

Dan Ferris

Editor's note: Dan focuses on finding great businesses trading for cheap prices in Extreme Value. He recently discovered a way to buy some of the world's most valuable real estate at an almost 50% discount. He has even called it "the perfect investment." Gain access to this recommendation with a 30-day, risk-free trial subscription to Extreme Value right here.

Further Reading:

"One of the secrets to finding the best investments is so simple and so obvious, most people don't pay attention to it," Dan says. But you could have used this secret to buy Microsoft for $4 a share in 1995... or McDonald's for $13 a share in 2003. Learn more here: Use This Simple Secret to Find the Best Stocks.

"Finance professors, advisers, and most brokers will tell you that to get market-beating returns, you have to take more risk," Dan writes. "That's not true at all." Get the story here: Our Strategy Beats the Market With Less Risk.

Market Notes

ANOTHER 'PICKS AND SHOVELS' WINNER

As we explained yesterday, "picks and shovels" companies are one of the market's surest bets. Today's chart shows more proof of this theory at work...

You may not have heard of KLA-Tencor (KLAC) before. The company works with the world's biggest chipmakers (like Intel and Samsung) to improve production yields by reducing the number of defective chips. In other words, KLA-Tencor's products and services are a form of "insurance" for the semiconductor giants that invest billions of dollars to produce cutting-edge technology.

KLA-Tencor isn't betting on the next big technology or fad. It's simply providing its services and knowledge to the world's biggest chipmakers. These companies are in a constant race to make their chips faster and smaller. That keeps KLA-Tencor's business steady.

As you can see, KLAC shares are in an impressive uptrend. They're up 50% in just the last nine months and just hit a new 18-month high. Business is booming for the leading "picks and shovels" company in the semiconductor industry...

The three things you must look for in an investment...

Dan Ferris shared the things you need to avoid as an investor in today's DailyWealth... But what are the things you need to look for?

Click here to get immediate access.

The Five Types of Stocks You Must Avoid

Market Notes

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