How to Make Money in a Declining Market

I have an admission: I haven't been buying lately.

You've probably seen the many articles proclaiming that stocks are on sale, but maybe, like me, you've encountered two things that have kept you from buying:

1. You're broke.
2. You fear that we haven't reached a bottom, and you're just not looking to see any more red in your portfolio this year.

Image source: Getty Images.

At The Motley Fool, we tend to focus less on the past 18 months, or the next 18 months, and more on the next 18 years, but this year has been unprecedented in many ways.

But since I do believe that this is a great time to buy, I reexamined the reasons I've been watching from the sidelines … and now I'm getting in. Let me tell you why, and then I'll also share what I believe is a sound strategy for generating positive gains in a market that seems to generate nothing but negative returns.

First things first.

Believe it or not, you're not broke
I grew up watching my Depression-era parents save soap shavings and regularly take stock of the non-necessities that should be trimmed from the family budget. I haven't had to resort to pulling the soap out from under my fingernails, but when I really looked at my budget, I saw plenty of places to cut.

In fact, I freed up almost $200 per month by cutting the following non-necessities from my budget: satellite radio, an online file storage service that I can't remember why I have, and vitamin-enhanced juice drinks (they're mostly sugar anyway).

In other words, if you're still able to pay off your monthly bills, you're not broke -- even if you're emptying your piggy banks to scrounge up lunch money. Finding ways to cut your expenses even a little bit can free up cash to invest.

Equities are on sale, and I'm confident that sacrificing these micro-luxuries is well worth the opportunity to buy stocks at these levels -- so that I'll be able to afford macro-luxuries in the future!

The market bottom (or not)
Ever heard of the "Rule of Holes"? As in, if you find yourself in a hole, stop digging? Too many investors think the Rule of Holes applies to investing in a declining market. It doesn't.

The benefits of buying into this declining market may seem less compelling now that the major market indexes are off 40% year to date, but the most important rule about declines is this: No one can call the bottom ahead of time. And if you wait for proof that the bottom has occurred, you'll miss the best buys.

That means that, if you're able to free up that $100-$200 per month (from your life's non-necessities) to invest, then this is the time to get in -- because you have a couple of powerful factors working to your advantage:

• Valuations are relatively cheap -- S&P 500 companies like Microsoft (NASDAQ:MSFT) are trading at less than 12 times forward earnings.
• History is on your side. Over the course of the 20th century -- which saw two World Wars, the Great Depression, and numerous financial calamities -- the stock market gained 10% per year on average. I believe it will return, whether we're at a bottom now or whether we see another 20% decline.
• Dollar-cost averaging allows you to hedge against further downward moves by taking advantage of lower prices.

But a market full of cheap valuations doesn't mean that every company is a good buy -- nor does it mean every portfolio will go up from here. So let me share with you my two-part strategy for maximizing returns in a down market.

Part 1: Avoid blowups
When the economy is in a recession, it's more important than ever to buy stable companies trading at reasonable prices -- it's what made Warren Buffett rich, after all. You'll want to look for companies with the following characteristics:

• Recession-resistant businesses.
• Positive free cash flow.
• Sufficient liquidity, as indicated by an interest coverage ratio above 3.
• Safe dividend yields, as indicated by a free cash flow payout ratio under 85%.

The following companies share these characteristics and have significantly outperformed the Dow, which has lost 36% in the last 12 months.

Source: Capital IQ and Motley Fool CAPS.

Yes, these companies were cherry-picked to prove a point. Pfizer (NYSE:PFE) and Merck (NYSE:MRK) have all four of those characteristics, too, but they've been hammered during 2008.

While not every company with these characteristics will outperform the market during downturns, all things being equal, they're the ones most likely to do so.

Take Axsys Technologies (NASDAQ:AXYS), for instance, which is far more growth-oriented than the usual bear-market value fare. It's a high-tech surveillance and security company whose services are in demand by the government, whether the GDP is growing or declining. Although it doesn't pay a dividend, Axsys has zero debt and grew third-quarter revenue 43% year over year. Even better, it has a strong backlog of government contracts.

Our Motley Fool Stock Advisor service recommended it in April 2008. Since then, it's gained 4%, compared to the market's 38% loss.

A recession-resistant business plan combined with strong financials goes a long way when the market is down.

Part 2: Diversify, manage your risks, and control your temperament
Although diversification, managing downside risk, and controlling your investing emotions are important in any market, they're critical in down markets.

You're never going to be 100% accurate in your stock-picking -- especially in the short term. Legendary fund manager Peter Lynch once said that you're doing pretty good if you can be just 60% accurate -- so don't fall prey to the fallacy of focusing on the success or failure of any single portfolio position.

What you should be focused on as a long term-oriented investor is the whole picture: Average performance over time compared to a benchmark. To outperform the benchmark, focus on choosing stocks whose potential long-term returns are well worth their riskiness. That's the best way to maximize your portfolio's overall return, which is all that really counts.

The Foolish bottom line
It's tough to keep a sense of perspective right now. So it's important for long term investors like us to remind ourselves that, while it's difficult to know exactly when, sooner or later the market will bounce back and reward those of us with enough stomach to handle the present volatility.

That's exactly what happened with Stock Advisor, which started recommending stocks in the down market following the dot-com crash. Even though we have recommendations that have doubled or tripled in value, we urge people to focus only on the big picture, because the big winners are only part of the story. Since its inception in 2002, our recommendations have outperformed the market by more than 25 percentage points on average. You can sign up for a free 30-day trial to learn more about how the Stock Advisor team can help your portfolio. Click here for more info.

John Keeling owns shares of Wal-Mart and Pfizer. Wal-Mart, Pfizer, and Microsoft are Motley Fool Inside Value recommendations. Pfizer is also an Income Investor selection and Motley Fool Holding. Axsys Technologies is a Stock Advisor pick. The Fool is investors writing for investors.