When Good Stocks Go Bad

Ever have one of those days? You know the ones I'm talking about. In investing, they arrive when that winner stock you were counting on suddenly barks like a dog and moves out to live with the neighbor's cats. It's enough to make your mouth pucker; like being fed spinach-flavored ice cream when you were expecting a delightful scoop of pecan praline.

But this happens to every investor. All too often, in fact. Take Fool co-founder and Motley Fool Rule Breakers chief David Gardner, for example. He recommended stun gun maker Taser (Nasdaq: TASR  ) at the height of its popularity over the past six months. Just check out the chart; most ski slopes don't look this steep. Subscribers who bought on David's recommendation are down more than 60%. Ouch.

It's taken a toll, too, on the overall performance of the Rule Breakers portfolio. Though recent selections have brought us into the black, Rule Breakers is underperforming the overall market by nearly 3% as of this writing. It doesn't have to be this way for you.

Rule Breaking with less risk
Investing is entirely about balancing risks vs. rewards. When you take a sizable risk -- such as investing in a potential Breaker -- you must be compensated by a reasonable chance of massive rewards. Invest in enough of these situations and, eventually, you'll win big. But most investors simply won't wait the years it sometimes takes to see informed speculations bear fruit, and they end up selling way too early. Or they cringe in fear at the idea of suffering a total loss.

Fellow Fool Jeff Hwang recently offered a solution for those suffering from this condition. He suggests investing in Breakers that produce plenty of free cash flow, boast top-flight management, and that can be had on the cheap. Makes sense, doesn't it? Of course, it does. It's also just one element short of a perfect model for buttressing a portfolio against disaster.

Ahoy, drop the ballast!
Remember: Perhaps 90% of Rule Breakers you'll ever run into are firms so early in their development that they're more likely to be burning cash than producing it. And they're almost never valued cheaply. eBay (Nasdaq: EBAY  ) , for example, has never been on the bargain rack. You're just not all that likely to create a portfolio of Breakers that's not astoundingly risky.

But who says you have to create a portfolio of just Breakers? Not us. Indeed, as fellow Fool Seth Jayson pointed out in sticking it to the Next Big Thing, you're probably better off focusing only a very small portion of your portfolio on speculative stocks, investing the rest in generating predictable, steady returns. The situation with Taser is a perfect example of why.

Seth says the best way to achieve this is by buying stocks on sale. I don't entirely agree. While I appreciate a good bargain as much as the next Fool, there's nothing I like more than the comfort of cold, hard cash when a good stock goes bad. That's right: I'm talking about dividends.

A stock in a storm
Ironically, I'm writing this from a hotel situated on the beach in southern Florida. The cool breeze of the ocean filters through the room. Lightning is visible off in the distance. Somewhere, the shores are being pounded by thunderous waves and driving rain. It's a great metaphor for what happens to a portfolio when Breakers go bad. Breakers like, um, Taser.

Or Nokia (NYSE: NOK  ) . Don't look at me that way. The mobile phone king was a Breaker that had become a Tweener five years ago. What's a Tweener? That's the period when the profits from an initial innovation -- in this case, the GSM mobile phone -- start to slow, and the company either becomes dominant in its industry or begins a slow descent into obscurity. Got that? OK, now rewind to 2000.

Nokia had nearly doubled sales over the prior three years heading into 2001. Accordingly, the stock was climbing into the stratosphere. But that year the Breaker broke, reporting slower sales and much lower earnings. Like Taser, it was a good stock that suddenly, and unexpectedly, went bad, even if the business hadn't. The fool who bet $5,000 on Nokia in 2000 would have $1,604.10 today for a loss of 68% (assuming a $20 commission for the initial purchase).

A dividend life preserver
Now look at what happened to the Fool who made that same Rule Breaking bet, but also diversified his $5,000 with a few boring, dividend-paying stocks:

Stock Cost Basis
6/2/00
Value
as of 06/03/05
Total
Return
Archer Daniels Midland (NYSE: ADM  ) $1,000 $2,024.34 102.4%
Citigroup (NYSE: C  ) $1,000 $1,124.48 12.4%
Kellogg (NYSE: K  ) $1,000 $1,748.36 74.8%
La-Z-Boy (NYSE: LZB  ) $1,000 $915.40 - 8.5%
Nokia (NYSE: NOK  ) $1,000 $326.60 - 67.3%
Portfolio Total $5,000 $6,139.18 22.8%
*All returns were calculated using historical data from Yahoo! Finance. Dividends were reinvested and a $20 commission applied to account for each initial purchase.

Yeah, I know, a 23% return over five years doesn't seem like much. But it was over these five years. From June 2, 2000 to June 3, 2005, the S&P 500 declined nearly 19%.

Get paid to invest
I didn't know what the returns would be when I set forth on this exercise, but I'm hardly surprised. You shouldn't be, either. Dividends have fueled stock market growth over the decades. Indeed, dividend payers have vastly outperformed the zero-payout crowd many times, such as during the 30 years between 1970 and 2000.

More recently, our own Mathew Emmert has delivered market-thumping returns for subscribers to his dividend-focused investing service, Motley Fool Income Investor. But there's more to a dividend than its yield and the opportunity for outsized growth. The plain fact is that nothing else in investing provides more immediate, tangible security for a portfolio than cash. Our model port above proves that; it managed to stay afloat despite suffering an albatross of the worst kind.

So, go ahead, swim with the Breakers. Just remember to take a life jacket. Get paid to invest.

Takearisk-free trialof Income Investor for 30 days. There's no obligation to subscribe. Ever.

Fool contributorTim Beyersloves to get paid to invest. He's waiting for someone to pay him to eat, too. Tim didn't own stock in any of the companies mentioned in this story at the time of publication. To see what's in Tim's portfolio, check out his Fool profilehere. The Motley Fool isinvestors writing for investors.


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