What Stocks Should I Not Invest In?

Perhaps as important as figuring out what the best stocks to buy are is identifying which stocks you should avoid. It turns out to be a lot easier than you might think but few know what to look for, so we’re going to pop the lid on the dangers that lurk under the surface to help you avoid them.

Take Peter Lynch’s Advice

Peter Lynch famously earned 29.2% annually during his tenure at The Magellan Fund from 1977 to 1990. One piece of advice, among the many tidbits he shared, ranks as perhaps the most important yet little understood.

If you’re wondering what stocks should I not invest in? Companies with poor balance sheets are best avoided, in Peter Lynch’s opinion. Specifically, Warner Bros Discovery (NASDAQ:WBD) is a stock to not invest in at this time, and here’s why.

On Warner Bros Discovery balance sheet is $3 billion of cash. No doubt, that’s a mountain of cash at first glance, and surely sufficient to ride out any economic storms. This is, after all, a company that includes under its corporate umbrella CNN, Food Network, Discovery Channel, Eurosport and more media brands. 

But a closer look at the balance sheet reveals the dangers that lie ahead for shareholders. Primarily, the company’s $44.29 billion poses a risk to investors because when at present interest rates of, even 5%, which is likely far understating what refinanced interest rates would be, the interest alone on debt would amount to over $2.2 billion annually. That’s almost the entire cash hoard in the corporate treasury.

But wait, it gets worse because in the most recent quarter WBD reported an operating loss of $769 million. At that quarterly pace, it would seem as if the company has no more than about 4 quarters before all of its cash has been used up.

In a situation like this, management is generally forced to shore up the balance sheet by selling off assets or cutting costs. It’s not like the company lacks a deep reserve of assets into which it can tap to lighten the debt burden. For example, it has $13.3 billion in current assets and $128 billion in total assets. But it does appear that the some asset sales will be needed, or at the very least some expenditure cuts are warranted.

Now there is a bit more than meets the eye here. Following the 2022 acquisition when Discovery and A&T closed the WarnerMedia transaction, significant one-time merger integration and acquisition-related depreciation and amortization costs were incurred. 

The company has managed to pay off about $9 billion in long-term debt over the past year and a half using cash on the balance sheet and working capital reconciliations from AT&T, but it’s also generating $1.7 billion in quarterly cash flow as of Q2 2023 and forecasts an additional $3 billion in Q4 2023.

Still, the cash flow situation is too slim for many conservative investors. It would be akin to having $3,000 in your bank account while saddled with $40,000+ in debt and using about $600 in monthly cash flow to pay down the burden.

So balance sheet is a major area of concern, but what else should you look to avoid?

SPACs

Special Purpose Acquisition Companies (SPACs) were very popular in the 2020-21 era when sponsors brought companies public through this channel versus the traditional IPO on the NASDAQ or New York Stock Exchange.

In the intervening years, SPACs have earned a poor reputation because the overwhelming majority of them have proven to be money pits. According to AGC Partners, 160 of 183 SPACs are under water. That’s a damning statistic if ever there was one so let’s think about it a little further. Why have SPACs proven to be so unsuccessful?

A large number of SPACs were brought to the market in order to raise cash in the hopes that the liquidity infusion would fuel the business model fire sufficiently to turn the companies profitable. 

The key thing is most were not generating profits and, as time went on, the capital injections were insufficient to turnaround poor business models. 

You could think about it this way, too. Why would a company go public via a SPAC if it could raise capital through a more traditional initial public offering? 

The latter requires the company to pass more stringent criteria than the former. So naturally SPACs attract some companies that are failing to meet key criteria needed to go public.  

So if you’re wondering what stock should I not invest in? Poor performing SPACs, like Doma, Hippo, Lemonade, Cazoo, Carlotz, Faraday Future, Innoviz and Ouster all make the list.

The Mirage of High Growth

Some companies are growth monsters. Google parent, Alphabet is one such example. Year after year, quarter after quarter, it reports higher numbers. 

The lure of revenue growth attracts many a new investor who pays close attention to the headline numbers of the top line but pays little attention to the bottom line.

What Wall Street really cares about, though, is profitability. Research analysts and institutions will, in fact, accept a company growing fast as long as it’s not losing money and they will even put a premium on those growing the top line quickly while reporting losses, but there has to be some sign over the horizon that the companies will be profitable.

Amazon is a classic example of a company that spent years growing revenues quickly but not reporting EPS in the black. It was acceptable, though, because Jeff Bezos and his team could, if they wished, turn some levers to create a profitable enterprise, whether that meant cost cutting or higher prices. In the end, AWS turned out to be the profit lever.

But other companies that post fast growth while losses simultaneously mount fall into another category because investors get skittish if they see those losses burn up cash piles on the balance sheet. When the cash is gone, management has few options, but none of them are good. For example, they can lay off a lot of staff which may hurt top line growth or they can issue a secondary which would dilute existing shareholders. 

These fast-growth companies that are increasing their operating losses quarter after quarter are typically the ones to steer clear of because they may be priced at a premium but one mist-step has the potential to result in a sharp correction.

What Stocks To Avoid?

So, if you’re wondering what stock should I not invest in? High growth stocks with increasing operating losses, SPACs, and companies with poor balance sheets make the shortlist.

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The author has no position in any of the stocks mentioned. Financhill has a disclosure policy. This post may contain affiliate links or links from our sponsors.