3 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 Berkshire Hathaway's 1997 chairman's letter, Warren Buffett 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, [many people] 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 Benjamin Graham to Bill 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 hint of a 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 Intel (Nasdaq: INTC  ) or Dell (Nasdaq: DELL  ) .

What if you come across that same company hitting 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 thousands of shareholders 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 Wal-Mart (NYSE: WMT  ) . The company hit my watch list in mid-April after I realized that the stock was a third off its high at the start of the millennium. Then, as story after story began appearing about weak retail sales and the beleaguered consumer, the uncertainty-hating market drove the shares down further (and I got out my cheerleading pom-poms ... um, I mean my bullhorn).

You see, stock price aside, Wal-Mart has been executing on nearly every front. Annual revenue growth of 11.3% since FY 2000 has translated to annual net income and free cash flow growth (net of expansion-related cap-ex) of 13.4% and 13.3%, respectfully, over that same period. Management was using free cash to aggressively expand the business (I estimate 70% of capital expenditures are targeted for growth initiatives) and buy back shares (the share count has been reduced by 7% since FY 2000). It has also tripled the dividend from $0.20 to $0.60 a share and whittled down its cash conversion cycle from a stellar 19 days in FY 2001 to 16 days by the end of Q2 2006. All indications are that management foresees no immediate slow-down in revenue or earnings growth, and believes there are much greater international expansion opportunities to boot. While I own a small long-term option position, I'd love to load up on shares at a sub-$40 price, so bring on the consumer negativity!

I'm also cheering down Anheuser-Busch (NYSE: BUD  ) and advanced test probe card manufacturer FormFactor (Nasdaq: FORM  ) even further. Anheuser-Busch, an Inside Value recommendation, is down since it was selected, but given its solid financials and stellar position in the industry, I smell a bargain. And so does Warren Buffett, who owns more than 5% of the company.

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 if you've picked good stocks that go up.

That's why I've twice been caught cheering for Portfolio Recovery (Nasdaq: PRAA  ) to get pummeled. The first time, I wanted to own the stock. The second time was this past spring. Fear of pending bankruptcy overhaul legislation drove what had been a $41 stock at Christmas to $32 by mid-April. But get this: Nothing had appreciably changed with the company, as was evidenced by a strong first-quarter financial release. I doubled my holdings at $35, and watched the stock rise back to $45 in September. Recently, performance fears (unfounded, in my opinion) for the debt-buyer industry and the passing of the new bankruptcy laws have driven the stock back to around $38. With two more strong quarters of performance under its belt, I've been getting gleeful again.

Cheer when you shouldn't
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 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 debt-holders to "put" the debt back to the company if conversion was not likely. When 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 knowledge will help you profit from the market's values, and it's just the kind of due diligence that Advisor/Analyst Philip Durell does at Inside Value. To date, he and his team are beating the market by three percentage points on the back of 25 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!

This article was originally published on Oct. 5, 2005. It has been updated.

Jim Gilliesowns shares of Portfolio Recovery and January 2007 $45 calls on Wal-Mart. Cheering for the misfortunes of others doesn't make Jim a bad person, does it? Dell is a Stock Advisor recommendation. Portfolio Recovery and FormFactor are Hidden Gems recommendations. Anheuser-Busch is an Inside Value pick. The Motley Fool has adisclosure policy.


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