November 11, 2008 - In today's market it seems every stock is a bad stock. Doesn't matter what you buy. It goes down. But I'm not talking about good stocks caught in a bad market. This is about bad stocks with no earnings and no real prospects, the ones with great stories but nothing else. Lots of promise, but no profits.

With that in mind, how should an investor control the urge to buy bad stocks or at least what's the best game plan for owning them? First, remember that the value of a stock, the current price at which it trades, is theoretically based on the stock's shareholder equity and future earnings discounted to their present value. That's where you have to begin. Understand that completely, and you'll never buy another stock that only has promise but no profits.

But we do buy them. Particularly biotech stocks that seem to have the answer for cancer or the common cold or other medical mystery yet to be solved. We imagine the gigantic markets for drugs that can cure these and many other ailments. But if we do any research, most of these companies have huge losses, year after year, and lots of presentations at medical conferences. They have great stories but no profits.

Some start-up technology companies have the same pattern: lots of potential for their latest innovations but no product and no profits. But if they only had more money, they claim, they could create the fastest, best, most unbelievable nano-tech device that does something that eventually would make all shareholders unbelievably rich. Have you heard this one?

Anyway, there is a sane approach to buying bad companies: Have the discipline to take 10% of your investable funds and commit it to companies that have very little chance of making money. Then with that 10% buy 10 different companies. Two things should spring immediately to mind of the sane investor: why would I buy a company with no profits and why would I buy a stock that has very little chance of making money? Because we do it all the time.

If you limit your exposure to these failures, you won't be exposing yourself to wiping out your wealth. And if you buy 10 different companies, you will diversify the risk across several sectors, giving yourself somewhat of a chance. Once in a while, one of these companies makes it. And that's all you can hope for: that one of the 10 makes it. If it does, it will more than compensate for the other 9 losers.

This is exactly the approach a venture capitalist takes on new companies that are looking for seed money. VC's know the odds are stacked against most companies due to competition or barriers to entry or poor management or any number of other obstacles. That's why they don't put too much of their money into any one company. They spread it around, believing each investment will be a home run but knowing, from experience, that most of them will strike out. The one that does knock the ball out of the park will more than make up for all the others.

Buying bad stocks is fun, at first. There's a tremendous rush of hope since there is the very infinitessimally small possibility that this is the one company that will actually beat the odds. Then, day after day, you watch them slowly sink (sometimes quickly sink) until they trade for pennies. You keep hoping things will change, but the fact is that every company needs cash to keep going. Eventually, these companies run out of cash, can't raise any more, and go out of business.

I wish it were different but after decades of buying bad stocks, I know the pattern all too well. I still buy bad stocks (sometimes they start out as good stocks). But I keep the amount of money in them at 10% or less and I buy a bunch of them. If you focus on the best stocks, but give into your need to buy bad stocks with real limitations, you can still indulge in the fantasy that one of your bad stocks may be a real super hero.

- Ted Allrich