Sell, Sell, Sell! Four Stocks to Avoid in 2016

There’s a common saying among investors, usually attributed to Warren Buffett, that goes something like this:

“There are two rules of investing. Rule #1: Don’t lose money. Rule #2: Never forget Rule #1.”

I know, I know… It seems simple enough (and a bit like the first rule of Fight Club), but the truth is we sometimes get so wrapped up in the stocks we love that we can forget to identify those we should be avoiding at all costs.

Whether you’re an experienced trader looking to short a stock or an everyday investor looking to lower your risk exposure, identifying failing companies is absolutely crucial to abiding by Rule #1.

Below, I’ve highlighted four specific stocks I personally wouldn’t touch with a 10-foot pole in the foreseeable future. Whether it be the ascent of disruptive technology or a simple matter of supply and demand, these four companies are all facing substantial headwinds that make them a major risk.

Even for those of you who like to take a contrarian approach, you can be quite certain these are not the discounted stocks you’re looking for.

Without further ado, here are four stocks you should short, sell, or at the very least not buy in 2016.

GameStop (NYSE: GME)

GameStop is a physical retailer of various video game products, including new and pre-owned console systems and physical software (discs and cartridges). The company also sells a variety of video game accessories, such as controllers, gaming headsets, memory cards, etc.

At first glance, GameStop is actually quite the compelling company to own. It trades at relatively fair value metrics, controls ~45% of the new video game software market, and has posted a profit for the last 20 straight quarters.

Yet nearly half of GameStop shares are currently being sold short, meaning the market is betting big that GameStop is going down. Why the negative sentiment? Well, the answer is simple: the rise of digital content.

Storage methods for video games, like any other form of media content, have rapidly evolved over the industry’s lifespan. At first, video games were built into entire consoles. Then they were put onto cartridges, and next onto discs.

Today, video game storage is going through yet another transition — the shift from physical disc storage to digital storage — and it stands to reason that this evolution is all but imminent.

For one, digital downloads make it easier for consumers to purchase and obtain the content they want straight from the comfort of their couch. Between increased Internet speeds and console storage capabilities, recent advances have made digital downloads more convenient for gamers than ever before.

Further, console makers such as Microsoft are making a strong push for digital downloads and are even beginning to toy with the idea of creating disc-less hardware systems. The benefits for companies like Microsoft would be two-fold, because A) customers are forced to purchase games directly through their online store, and B) disc-less consoles would be cheaper to produce.

Digital downloads are jointly a major benefit to video game publishers looking to maximize sales. By keeping video games in digital form, publishers can cut down on the reselling of used games between gamers, because there is no physical product to transfer.

This inevitable shift from physical to digital puts an incredibly dark cloud over the GameStop franchise. The company has 6,627 physical locations worldwide and relies on used video games for 24.9% of its net sales. Pivoting to a digital model would be near impossible for the company.

Should the video game industry fully adopt the digital storage trend, GameStop would be in for an incredibly rough ride, reminiscent of what Blockbuster went through when movie and television consumption began to shift to digital format thanks to competitors such as Netflix.

Rosetta Stone (NYSE: RST)

Most investors have been familiar with Rosetta Stone (NYSE: RST) for some time now.

The company provides language-learning software and is widely recognized as the leader in its respective market.

For between $500 and $900, you can become completely fluent in virtually any language — that is, of course, if you’re willing to put in the time and effort.

When Rosetta Stone first hit the public market in 2009, excitement was high, and company shares jumped as much as 44% in its first day of trading.

Over the last half-decade, though, Rosetta’s revenue growth has remained nearly flat, and operating expenses have continued to increase, the result of which has been a negative trend in net income that should make any shareholder nervous…

As you can see in the image above, Rosetta Stone hasn’t turned a profit since 2010. It lost over $55 million in 2014 and has less than $34 million left in cash left (compared to $98 million cash in 2013).

More importantly, though, Rosetta Stone is selling a product that’s becoming effectively useless. For one, there is free language software available (Duolingo) that’s proven more effective than Rosetta Stone. Further, advances in universal translation apps may soon remove the need to learn new languages altogether.

In 2015, Google (now Alphabet Inc.) released its latest version of its Google Translate app, which could represent a major threat to Rosetta Stone’s business model…

First, the app uses technology from Word Lens, a company acquired by Google in May of 2014. This technology allows Google Translate to read text in virtually any language using the camera on your smartphone and translate it back to the language of your choice.

The feature is particularly useful in translating signs in foreign countries, and it even works in Cyrillic script.

Google Translate can even translate languages in real time. It’s like having your own personal translator follow you everywhere you go, and unlike Rosetta Stone, it’s completely free.

With five years of cash burn on the books and disruptive technology on its heels, Rosetta Stone is a stock that’s just not worth the risk.

Outerwall Inc. (NASDAQ: OUTR)

Outerwall Inc. operates a line of automated retail machines, the most notable being its flagship Redbox DVD rental kiosks.

In addition to Redbox, Outerwall’s product portfolio also includes its Coinstar coin-cashing machines and its EcoATM kiosk, which dispenses money in return for unwanted personal electronics.

But Redbox is Outerwall’s biggest business by a mile, accounting for more than 80% of the company’s net sales. Any decline in this specific segment is bound to have a huge impact on the parent company…

Unfortunately for Outerwall, Redbox has been drastically underperforming in recent months due to a combination of disappointing releases at the box office and — more importantly — a continuous shift towards digital movie rentals.

In fact, in 2015, Outerwall stated the brand had experienced “the worst theatrical box office… in four years.”

In addition to declining sales, management is already running for the hills. Outerwall recently announced that Mark Horak will be stepping down as president of the company after just over a year at the helm.

Horak took the position as president in March 2014 after nearly 20 years with Warner Bros., but even with his two decades of experience in the home entertainment industry, Redbox’s business could not be buoyed.

Over the last two years, the company has been forced to shut down Redbox Instant (an attempt to compete with Netflix) and has closed more than 300 kiosks in the U.S. In 2015, the company pulled out of the Canadian market entirely.

Simply put, Outerwall’s Redbox can’t compete with other home entertainment delivery services such as Netflix, Apple TV, Hulu, etc.

PwC (PricewaterhouseCoopers) predicts that electronic home video will overtake the box office as soon as 2017. The market is expected to bring in $17 billion by 2018, doubling current sales figures.

During the same period (2014-2018), physical home entertainment revenue is forecast to fall more than 28%, from $12.2 billion last year to $8.7 billion in 2018 — obviously not a pretty picture for the Redbox-dependent Outerwall Inc.

In 2015, Outerwall’s stock shed a whopping 50% of its value, with no solid floor in sight. At single-digit P/E ratios, it might look like there’s hidden value here, but investors would be wise not to try catching this falling knife.

Chesapeake Energy (NYSE: CHK)

In 2015, debt and pricing woes began threatening countless firms across the oil and gas industry, especially those located here in the States.

When you combine the North American shale boom with years of low-interest financing, what you wind up with is a boatload of companies funding costly exploration and drilling operations on top of massive piles of debt.

As a direct result of these two factors, oil production exploded in the years leading up to 2015, resulting in a massive supply glut and a subsequent drop in oil and prices across the globe. This may have been a godsend for consumers of oil-based products, but it’s been an absolute disaster for oil-producing firms.

Simply put, it’s become increasingly likely over the last several months that many energy companies out there will be unable to repay what they owe, leaving many public investors out in the cold. And while there are a great number of companies now at risk of default, one firm stands out above the rest.

By the end of 2015, Chesapeake Energy (NYSE: CHK) — the second-largest natural gas producer in the United States — recorded just $1.76 billion in cash and a whopping $10.7 billion in debt.

Shares of the company fell 77.3% last year, making it one of the worst-performing stocks in the S&P 500, and the headwinds certainly won’t be letting up in 2016.

On top of multiple analyst downgrades citing items such as “weak natural gas price forecast and balance sheet concerns,” Bespoke Energy Group recently warned: “The wave of energy defaults looming in the wings could make for some very bumpy roads ahead in 2016.”

Perhaps even more frightening for Chesapeake shareholders is the fact that OPEC recently stated in its annual World Oil Outlook that it doesn’t expect oil to return to $100 a barrel for at least the next 25 years.

For a company that’s now burning nearly $5 billion in cash a quarter due to low oil prices, the future is looking especially grim. Shares might look like they’re trading at a discount, but the chance of default makes Chesapeake Energy a stock that’s just not worth the risk.

Until next time,

Jason Stutman

Check us out on YouTube!