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2 Stocks to Avoid in 2013

Tuesday - 1/1/2013, 2:57pm  ET

The world is full of enough uncertainties going into 2013 -- all the more reason not to burden our portfolios with stocks shrouded in uncertain outcomes. Instead of looking at what investments could turn out to be potential winners in 2013, I'll examine two stocks to avoid. To make the determination to avoid a stock, we must first separate the notion of a good business from a good investment.

A good investment should meet three criterion. It should have:

  1. Understandable business economics
  2. A durable competitive advantage
  3. A margin of safety

The criterion above are in order of precedence. A business can only be deemed to have a durable competitive advantage if the investor understands the business. Furthermore, the forecasts and predictions needed to determine whether the business is trading at a discount to fair value are only relevant if the business has a durable competitive advantage. Most investing outside of these parameters is purely speculation (or cigar butt investing for those who participate in asset plays).

In other words, a good business isn't always a good investment. For example, a business may pass criteria number one and two, but it is clearly overpriced to merit a sensible investment and, hence, fails criteria number three.

Let's take a look at some examples. Without further ado, two investments to avoid in 2013:

1. Pandora

Most people like to start the new year with some encouraging resolutions. Pandora went into the new year by slashing its 2013 guidance, estimating a loss of 9 to 12 cents per share. Pandora passes on criteria number one, but it fails on number two. Due to the low barriers to entry in the streaming music business, companies with much larger balance sheets (e.g. Amazon , Apple , Facebook, and Google) are able to introduce competing services and tap into their existing resources and users. Some of these competitors already have more experience in the music business.

Plus, there are numerous rumors that Apple is already working on its own Pandora-like music service. Apple's TTM free cash flow of $40.5 billion alone is equal to 30 times Pandora's market capitalization. With millions of iTunes customers across the world, Apple already has access to the largest digital music customer base in the world. A competitive offering from Apple could very well represent the beginning of the end for the much smaller Pandora that is already forecasting a loss for the next 12 months.

2. Barnes & Noble

Barnes & Noble is in a dire situation, failing on criteria number two: 92% of the business is in decline and the other 8% (the Nook segment) is trying to take on Apple and Amazon. With just $160 million in sales during the quarter, Barnes & Noble's Nook segment pales in comparison to its competition. In a press release on Dec. 27, Amazon announced that "Kindle Fire HD, Kindle Fire, Kindle Paperwhite and Kindle hold the top four spots on the Amazon worldwide best seller charts since launch." Meanwhile, Apple floods the market with tens of millions of tablets every quarter while raking in 27 cents of free cash flow on every dollar of sales. If investors are counting on Barnes & Noble's Nook division to save the stock, they should expect some serious headwinds.

The Bottom Line

Pandora and Barnes & Noble lack durable competitive advantages to protect future cash flows. Bigger, stronger, and better equipped competitors are potential threats to both Pandora and Barnes & Noble. When the core business is threatened, an investment becomes speculation. And speculation is not my game -- I'd rather take my money to the slot machines in Las Vegas.

 

This article was originally published as 2 Stocks to Avoid in 2013on Fool.com

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