Now Is the Time to Upgrade Your Stocks

This time, like all times, is a very good one, if we but know what to do with it.
-- Ralph Waldo Emerson

Since March 2009's market bottom, we've seen what many derisively call a "junk rally" -- stocks with obvious problems (e.g., debt-laden balance sheets, huge losses, etc.) have risen faster than solid "blue-chip" stocks.

Just look at your favorite multibagger -- Ford, Freddie Mac (NYSE: FRE), Citigroup, or Las Vegas Sands -- for evidence.

But here's a secret about the so-called junk rally. I don't care whether you label a stock "junk" or you label it a "blue chip." And I don't care about the amazing run-ups that have made your neighbor a killing.

I only care about the answer to one question.

That one question
When a stock doubles or triples or whatevers in price, it's hard to think rationally about it. Bulls think, "How can a stock that created such fortunes be a bad investment?" Bears think, "How can a stock that rose so much be considered cheap?"

This relative valuation problem is the same trick stores play on us. At 50% off, we instinctively believe we're getting a bargain regardless of the absolute price. But, in reality, only the absolute price matters -- either a shirt's worth $50 or it's not. It's the same thing with a stock price.

Whether a stock is downtrodden like so many were last March, or it's coming off a huge hot streak like many are now, we investors need to focus on one question:

Is the stock worth owning at today's prices?

How can you tell?
The first thing to realize is that no stock is a sure thing. But some stocks are less likely to leave you heartbroken than others. The higher a company scores on these four attributes, the more you should be willing to pay for its stock:

1. Strong balance sheet.
2. History of solid profitability.
3. Sustainable competitive advantage.
4. Strong growth prospects.

But even if it scores poorly, it may be a good buy if the price is low enough. In fact, if the price is right, a "junk" stock can be more attractive than a "blue-chip" stock on a risk-adjusted basis.

The reason stocks like Ford, Freddie Mac, Citigroup, and Las Vegas Sands rose so much during the rally is because the market had beaten them down to such a low level back in March 2009. The market was driven by fear for the worst, so companies with serious bankruptcy risk were priced as such ... and then some.

You may argue that all stocks were down significantly at the bottom. This is true. Still, higher-quality stocks like McDonald's (NYSE: MCD), IBM (NYSE: IBM), Boeing (NYSE: BA), and Visa (NYSE: V), while trading lower, weren't beaten to the floor like the Las Vegas Sandses of the world.

A word of caution
But let's not pick nits. Just about any investment made last March has done very well. If you had the fortitude to take advantage, I offer you congratulations -- but I also offer you a warning.

With the stock market no longer priced for financial Armageddon, now is the time to look at the risk-reward profiles of all your holdings. The market has been fairly stable recently, but don't be lulled into a false sense of security.

As the ancient Roman poet Horace put it, "A heart well prepared for adversity in bad times hopes, and in good times fears for a change in fortune."

In other words, now is the time to upgrade your stocks.

Let me upgrade you
Whether your portfolio is full of "blue-chip" stocks or "junk" stocks, you must be vigilant to ensure the current price is fair. The worse the balance sheet, profitability, competitive advantage, and growth prospects of a company, the less a stock should be worth to you. This is the case if you're newly buying a stock or just holding it in your portfolio.

Given all this, I'd be remiss if I didn't give you a couple of upgrade ideas for any overvalued stocks in your portfolio.

So I turned to The Motley Fool's founding brothers, David and Tom Gardner, for the stocks they like at today's prices. Both of the stocks below made the Best Buys Now list in their monthly investment service, Motley Fool Stock Advisor.

If you find a weak link or two in your portfolio, Activision Blizzard and Western Union are good research candidates to start your upgrade process. If you'd like to see all of David's and Tom's Best Buys Now (10 total), I invite you to try their Stock Advisor service free for 30 days. Click here to get started. There's no obligation to subscribe.

This article was originally published Feb. 5, 2010. It has been updated.

Anand Chokkavelu owns shares of McDonald's and Citigroup. He may have used Emerson's quote, but he always believes in a Thoreau analysis. Western Union is a Motley Fool Inside Value pick. Activision Blizzard, Ford Motor, and Western Union are Motley Fool Stock Advisor selections. Motley Fool Options has recommended a synthetic long position on Activision Blizzard and a covered calls position on Western Union. The Fool owns shares of Activision Blizzard and has a disclosure policy.