Stocks on the Slide

The desire to follow the crowd is a simple truth of human nature. But when it comes to investing, the momentum that builds up around popular stocks breeds irrationality. Stocks on the rise rarely rise forever.

If that's true for stocks that have seen impressive run-ups, it's also true on the flipside. The history of the market has shown that investors tend to buy or sell when everyone else is doing likewise. So, stocks are sold en masse just as irrationally as they're bought -- if not more so.

Is it that easy, then?
When a stock is being dumped indiscriminately, should you jump in with those finely honed contrarian instincts of yours?

Here's my wholly dissatisfying answer: Sometimes, but not always. Let's explore a few recent and startling examples of stocks on the slide.

2005 was not kind to Jo-Ann Stores, Imergent, or Cogent Communications. And even with the recent surge for large-cap companies, investors have been bullish about these small caps this year, propelling them each to double!

In these cases, being a contrarian and scouring the discard piles would have yielded astounding rewards.

For an ultimate example, look at the early public life of Netflix (NASDAQ:NFLX). A few months after its IPO, the market started to fear the advent of similar rental services from Blockbuster, Wal-Mart, and Amazon.com. Initially offered at $15 per share, Netflix stock plummeted 50%. This was a tough environment, but investors who bought at lows, confident in Netflix's long-term potential and community-based recommendation system, have been very happy with their contrarian play -- they are sitting on a seven-bagger for their pains.

Gravity ... what a phenomenon
But it's not as simple as being contrarian and looking for 52-week lows or steep price declines. We've probably all held or bought companies that we were sure would rebound, only to have the entire investment vanish to almost nothing. For every sliding stock that turns into a multibagger, several more fizzle. Here are some recent examples of the "down, downer, downest" phenomenon.

So how do you play this game?
The legendary investors espouse one simple rule: Buy great companies at a good price. Don't speculate on the hot stocks that are on everyone's lips. As Peter Lynch wrote in One Up on Wall Street, "If I could avoid a single stock, it would be the hottest stock in the hottest industry, the one that gets the most favorable publicity, the one that every investor hears about in the carpool or on the commuter train."

Instead, buy the stocks that have been beaten down unfairly -- because of a bad quarter, a change of CEO, a patent expiration in an otherwise deep pipeline. The market tends to overreact and sell these stocks just as irrationally as it buys the hot stocks everyone else is buying. Find companies with solid fundamentals, and make sure the market overreaction is not justified.

But just how do you do this? These three rules can help:

1. Find companies that have high or improving returns on capital.
2. Look for innovation in the company's product lines or business model.
3. Determine that the company has a strong competitive advantage compared with others in the industry.

Protect your portfolio
Netflix had all three of these things going for it, even during the sell-off I discussed above. But you don't have to find newly public small caps to be a contrarian investor.

Colgate-Palmolive has been around for 200 years, but it was a stock on the slide about a year and a half ago. After one bad quarter, marked by higher advertising spending and raw-material costs, Colgate's bottom line plummeted. Short-term negativity made the stock price decline by more than 26%, but a savvy investor who saw Colgate's stalwart and longstanding potential could have gotten in at the bottom.

For companies with solid fundamentals and competitive advantages, dips are just a way for investors to buy more.

Motley Fool Inside Value analyst Philip Durell recommended Colgate to subscribers of the newsletter when it was trading in the mid-$40s in late 2004; it's now near $65. As a contrarian investor who always waits for the right price, Philip has been able to keep his entire Inside Value portfolio in the black.

For free access to his current value-priced stock recommendations, more than half of which are still trading at a discount to their intrinsic values, simply click here for a free one-month trial. There's no obligation to subscribe.

Stocks on the run can be dangerous to follow. But don't go chasing stocks on the slide, either. By finding great companies with solid fundamentals, you'll limit your risk in a volatile market.

This article was originally published June 30, 2006. It has been updated.

Fool sector head Shruti Basavaraj has experienced sliding before, mostly on thin ice. Shruti does not own shares of any company mentioned in this article. Netflix and Amazon.com are Stock Advisor picks. Wal-Mart is an Inside Value pick. The Fool's disclosure policy has a non-skid coating.