2 Ways to Profit From the Drop

Frankly, it's been a terrible two months to own stocks.

The shame is that as recently as mid-October, investors were getting ready to brag about what was a "pretty good year." The S&P 500 was up 10% and the Russell 2000 was up 7%.

Then November happened.

A curse and a blessing
Times like these are neither fun nor profitable, and there's only so much solace one can take in a tax break. The good news is that down markets give us two ways to position our portfolios for long-term outperformance. Down markets allow investors to:

  1. Take advantage of the opportunity to buy great companies on the cheap.
  2. Learn from now-apparent mistakes and resolve to never make them again.

Now, we've written at length about some of the bargains in today's market, so I'll focus on the second point today.

On tides that rise and the boats they float
The fact of the matter is that even terrible companies can reward shareholders during hot markets. For evidence, look no further than 1999. Of the 542 stocks that doubled that year, 208 of them did not turn an annual profit.

While some of those names are now profitable, if you'd put $1,000 into all 208 stocks back in 1999, you'd be down 72%. What's the lesson? It will vary from stock to stock. In the case of Nortel Networks (NYSE: NT  ) , it might be to be wary of companies that have high ongoing R&D expenditures; for JDSU (Nasdaq: JDSU  ) , the lesson would be not to pay a stiff premium for a business that hasn't yet proved it can consistently make money.

Yes, the market can sour on even the greatest of companies because of short-term hiccups. But when severe underperformance persists over multiyear periods, it's important to realize that some share of the problems lies with the company ... not with the market.

Get rich or die tryin'
We all make investing mistakes. The key is not to make them again.

We've been dealing with this at our Motley Fool Hidden Gems small-cap investing service. Small caps have been among the hardest hit by the recent market swoon, and Fool co-founder Tom Gardner is coming to terms with what he called "one of the worst stocks I've ever recommended."

That stock is mattress-maker Select Comfort, and despite having a quality product, management has been slow to learn from its marketing mistakes and adapt to declining demand. That's putting it mildly for a stock that's down nearly 60% year to date, but in Tom's opinion, the problem is at the top.

Lose and learn
Tom's autopsy of this recommendation has yielded a four-point checklist that should help make us all better investors:

  1. Make sure the CEO at your companies has been pursuing mastery in a relevant industry for more than a decade and demonstrates daily passion for the business.
  2. Make sure the company is taking bold steps that match up with your beliefs about the company's potential. If you come to believe you can do a better job of running the company than its leadership, it's time to sell.
  3. Make sure your company has leadership that in every way demonstrates partnership with each of the constituents of its business -- customer, employee, and, perhaps most important, shareholder.
  4. Make sure you have a diversified portfolio to fall back on if you turn out to be wrong.

These observations make sense. The greatest business leaders of our time have been passionate and bold. That list includes Apple's (Nasdaq: AAPL  ) Steve Jobs and Costco's (Nasdaq: COST  ) Jim Sinegal.

Someday it might also include Middleby (Nasdaq: MIDD  ) CEO Selim Bassoul and Barrett Business Services (Nasdaq: BBSI  ) CEO Bill Sherertz, the ebullient heads of two impressive small companies we've highlighted at Hidden Gems.

Even John Mackey's recent legal problems at Whole Foods (Nasdaq: WFMI  ) were more the consequence of passion than anything else. We can argue about the propriety of his message board postings, but that company's returns over the years speak for themselves.

Be one and done
Tom's still deciding what to do with Select Comfort. The important point, however, is that our experience -- our mistakes -- with the company will inform our thinking from this point on. That's crucial when it comes to investing, because if we only make each mistake once, they will be footnotes to our fortunes as we crush the market over the next few decades.

That, after all, is our goal at Hidden Gems, where we strive to pick better and better stocks for our subscribers each and every month. And despite our experience with Select Comfort, our diversified list of recommendations remains 26 percentage points ahead of the market on average since inception in 2003.

Click here to join us free for 30 days and enjoy immediate access to all of our research and recommendations, including today's two brand-new picks, releasing at 12 noon ET.

Tim Hanson owns shares of Whole Foods and Barrett Business Services. Select Comfort and Middleby are Motley Fool Hidden Gems recommendations. Whole Foods and Costco are Motley Fool Stock Advisor recommendations. The Motley Fool has a disclosure policy.


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