Three Cheers for a Bear

I have a confession to make: I sometimes cheer a good crash. In fact, if it's a really big blow-up, I often revel in the destruction. No, I'm not talking about highway mishaps here. I'm talking stocks.

In BerkshireHathaway's 1997 chairman's letter, Warren Buffett famously wrote:

If you plan to eat hamburgers throughout your life and are not a cattle producer, should you wish for higher or lower prices for beef? ...

Even though they are going to be net buyers of stocks for many years to come, they are elated when stock prices rise and depressed when they fall. In effect, they rejoice because prices have risen for the "hamburgers" they will soon be buying. This reaction makes no sense. Only those who will be sellers of equities in the near future should be happy at seeing stocks rise. Prospective purchasers should much prefer sinking prices.

Buffett's wisdom is the secret of successful value investors from Graham to Ruane and is also the heart of Philip Durell's Motley Fool Inside Value newsletter, where we seek to buy the proverbial dollar for 75 cents. Yet, so many, myself included, often forget this crucial strategy at the first blush of a September swoon.

In that vein, here are three examples of why you should cheer as the fire rages.

Cheer your wish list down
You've found a company you'd love to own, but your analysis tells you it's expensive. What do you do? Buy it anyway, or wait?

If you said, "Buy it anyway," you've just made the mistake of confusing a great business with a great stock. Valuation matters. Just ask the investors in bubble-era titans such as Cisco (Nasdaq: CSCO  ) or Microsoft (Nasdaq: MSFT  ) .

What if you come across that same company making new daily lows? What if, after due diligence, you find improving operations and financials, and a stock trading at ever more compelling levels? Well, if you're like me, you start to cheer that dog down! I'm not unfeeling; I realize there are already thousands of shareholders, many of whom likely sitting white-knuckled willing the stock to cease tumbling. But I just don't care. (OK, perhaps I'm a little unfeeling). I care about what I pay for a company, and I like bargains.

Wishing for lower lows
A recent example is 3M (NYSE: MMM  ) . Originally appearing on my watch list after a disappointing first quarter, approximately 12% was taken off the stock in April alone. Then the CEO announced his departure, and the uncertainty-hating market really got to work (and I got out my cheerleading pom-poms ... um, I mean my bullhorn).

You see, 3M is a company improving on nearly every front. Margins expanded as annual revenue growth of 5% since 1999 translated to annual net income and free cash flow growth of 10.7% and 12.3%, respectively, over that same period. Management was using cash to reduce the dilutive trend of five years ago, actively buying back shares. The dividend had grown 6.5% annually while falling by a fifth on a payout basis (the ratio of dividends to earnings per share). Net debt fell from $2.5 billion to a mere $44 million at the end of the second quarter. The company's cash conversion cycle improved from 113 days to 82 days. Finally, a substantial post-stock-bubble deficit in the company's defined-benefit pension plan had been funded from operating cash flow, to the tune of $2.4 billion over the past three years. With that deficit largely beaten, there will now be even more cash to go around going forward.

Then there's the cheering I'm doing to will down Home Depot (NYSE: HD  ) and private post-secondary education provider StrayerEducation (Nasdaq: STRA  ) even further.

Cheer your own portfolio
Peter Lynch once wrote, "The best stock to buy may be the one you already own." Unfortunately, that can be difficult to practice if you've picked good stocks that go up.

And that's why I've twice been caught cheering for Garmin (Nasdaq: GRMN  ) to get pummeled. The first time, I wanted to own the stock. The second time was this past spring. First-quarter growth disappointed the market, and a $62 stock at Christmas became a $39 stock by the end of April. But get this: Nothing had appreciably changed with the company. I started buying more at $40, when the insiders started buying, and doubled my holdings. The stock is trading back at its $62 level.

Cheer when you shouldn't be
The danger in all of this cheering is that you catch a falling knife and double down before all of the bad news is out. Consider what happened when I bought shares in Shaw Group (NYSE: SGR  ) at $22.

Shaw made money on engineering and maintenance contracts from power-plant construction projects. When some counterparties began to default on those contracts, the stock fell from $32 to $16. I cheered that fall and bought more at $16.

How foolish (small-f) of me. You see, I missed a key characteristic of the company's debt. Convertible to equity at a price far higher than the current stock price, the debt also had a proviso for the debtholders to "put" the debt back to the company if conversion was not likely. As the company went cash-flow negative stemming from the contract defaults, it was clear that the put option would be exercised, and Shaw would need to find a lot of cash it didn't have. That $16 stock quickly became a $10 stock.

The Foolish bottom line
The key is knowing when should you cheer on a stock's demise and when you should run away screaming. How do you do that? By knowing the value of your company, the debt structure, the options on that debt, the CEO's middle name ... you get the idea.

That kind of due diligence will help you profit from the market's values, and it's just the kind of due diligence lead analyst Philip Durell does at Inside Value. To date, he and his team are beating the market by six percentage points on the back of 26 active recommendations. To access all of the buy reports and most recent updates, click here to take a 30-day free trial. There is no obligation to subscribe.

Because if you can't knock any holes in your investment thesis, then get out those disaster pom-poms ... I mean, bullhorn. And trust me, no one should think less of you!

Home Depot and 3M areInside Valuerecommendations.

Jim Gilliesowns shares of Garmin and has a synthetic long position in 3M. (That means he's long Jan. 2008 $75 calls and short Jan. 2008 $75 puts.) Cheering on the misfortunes of others doesn't make Jim a bad person, does it? The Motley Fool has adisclosure policy.


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