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After you’ve been investing for a while, you begin to see the bright side of share-price declines, because they often present opportunities to buy great companies at discounted prices.
Not every beaten-down stock is a good investment, though. Sometimes, stocks fall for good reason, and buying them after a significant crash is actually a value trap instead of a bargain opportunity.
To avoid catching falling knives, you have to be able to distinguish the quality companies the market is overlooking from the struggling businesses that will likely continue to face challenges. To that end, I never invest in beaten-down companies if I see these two red flags:
The company will likely need to raise more money to fund operations.
The business is facing secular headwinds.
Let’s unpack these two concepts by looking at an example: Peloton Interactive (NASDAQ: PTON).
Image source: Getty Images.
Avoid zombies like the plague
A zombie company is a business that is on a path toward insolvency unless it manages to raise additional capital, either in the form of an additional equity offering (selling more stock) or by taking on new debt.
These companies are completely dependent on new capital injections to survive, and when interest rates start to rise and the market becomes more averse to risk, they’re often forced to take on new debt at very unfavorable interest rates, exacerbating their balance-sheet woes.
Peloton has certainly struggled in the last year with demand dropping off a cliff and operating expenses rising.
This led Dave Trainer, the CEO of the research firm New Constructs, to say the following in a recent publication: “Peloton’s issues are well telegraphed — given the stock’s decline over the past year — but investors may not realize that the company only has a few months’ worth of cash remaining to fund its operations, which puts the stock in danger of falling to $0 per share.”
Trainer’s harsh comments are substantiated when you look at the company’s shrinking cash position:
Metric
June 30, 2020
June 30, 2021
March 21, 2022
Cash*
$1.75 billion
$1.60 billion
$879 million
Data source: Peloton earnings reports. *Includes cash equivalents and short-term investments.
The interactive fitness specialist is also burning cash at an accelerated rate, going from free-cash-flow positive in 2020 to reporting negative free cash flow for five straight quarters. And the fiscal third quarter saw the biggest outflow yet of $746.7 million.
While Peloton’s newly appointed CEO, Barry McCarthy, is hoping to pull off the comeback of the decade, Peloton is a company that may soon be raising capital in an environment where doing so is no longer cheap.
Pass on businesses operating in declining markets
Another major red flag is when a company operates in an industry with major secular headwinds. Peloton had a tremendous first-mover advantage which it cashed in during the pandemic as the connected-fitness industry enjoyed a surge in popularity. But as things have started returning to normal, the at-home fitness sector has experienced a complete reversal with waning demand, which is visible in Peloton’s rapidly slowing revenue growth.
Metric
Q3 2021
Q4 2021
Q1 2022
Q2 2022
Q3 2022
Revenue growth
141%
54%
6%
6%
(15%)
Data source: Peloton earnings reports.
And Peloton is not alone. Rival fitness brand Nautilus recently announced a 70% decline in sales in the most recent quarter, while the parent company of NordicTrack scrapped its plans to go public this year among various rounds of layoffs.
The at-home fitness equipment industry may eventually live up to the hype, but for the foreseeable future, it faces an uphill battle as fitness enthusiasts elect to return to gyms and outdoor activities.
Buy the dip, but do it intelligently
I’m a huge proponent of buying beaten-down stocks as long as they’re high-quality companies. And to determine that, you need to be on the lookout for red flags.
As you can see with Peloton, the potential need to raise capital to fund operations (especially when interest rates are rising) and major industry headwinds are two indications the stock could be a falling knife instead of a diamond in the rough.
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Mark Blank has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Peloton Interactive. The Motley Fool has a disclosure policy.
