Can You Predict a Crash?

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As 1999 drew to a close, Microsoft (Nasdaq: MSFT) had all the hallmarks of an exceptionally strong business:

• More than $17 billion in cash and equivalents on hand.
• No long-term debt.
• More than $2.4 billion in profits for the quarter.
• Tremendously strong growth on a year-over-year basis.

So what happened next? Microsoft's stock, along with much of the rest of the tech market, crashed.

Come again?
The problem, of course, was valuation. At the time, the market valued the entire business at $586 billion. Even if you assumed that its profits would continue at such a strong level (and by that point, Microsoft was already a dominant firm that defined its market), it traded hands for more than 60 times its anticipated earnings.

So while you probably couldn't have predicted when the crash would happen, simply by taking a step back and looking at its published numbers, you could have certainly picked up some sense that the stock had gotten ahead of itself.

So what?
Nobody knows for certain what any particular stock is going to do next. Over long periods of time, however, one factor absolutely dominates in determining a company's stock movements: financial performance.

You can use this information to your advantage. Because the short-term stock market is unpredictable, stocks can sometimes trade at prices far away from where valuation would suggest would be reasonable. And by choosing your investments when they're attractively valued (rather than overvalued), you can put yourself in the position to profit.

That's how we've managed to beat the market at Motley Fool Inside Value since its 2004 inception. Could we accurately predict that our pick of Outback Steakhouse parent company OSI Partners (NYSE: OSI) would be the target of a private capital buyout? No. All we knew was that OSI's shares were trading far below where they should have, given the cash it could generate once it turned itself back around.

Twiddle your thumbs profitably
Of course, it can be maddening to buy a cheap stock, only to be forced to wait for an eternity for that company to return to a proper valuation. That's why I like to look for companies that:

• Are profitable.
• Pay dividends.
• Look to be bargain-priced.
• Have positive "sustainable growth": return on equity multiplied by the retention rate.

Here are just a few businesses that recently passed that test:

Company	TTM Earnings*	Current Yield	Price to Book	Sustainable Growth
Citizens Republic Bancorp (Nasdaq: CRBC)	$74	6.0%	0.92	1.13%
Phoenix Companies (NYSE: PNX)	$149	1.0%	0.77	5.89%
Building Materials Holding Corp (NYSE: BLG)	$69	2.6%	0.80	10.74%
Aspen Insurance Holdings (NYSE: AHL)	$420	2.2%	0.96	16.43%
IPC Holdings (Nasdaq: IPCR)	$392	2.2%	0.96	19.29%

*In millions. Excludes non-recurring items.

The cash payment takes the pain out of waiting, the bargain price gives you a better chance for an upside, and the positive sustainable growth suggests that the future looks anything but bleak. You still can't predict when a company's price will move, but by knowing what to look for, you can stack the deck in your favor. To avoid the odds of buying the next pre-crash Microsoft, and improve your chances of finding the next pre-takeover OSI, take a 30-day free trial of Inside Value. Once you join us, you'll see just how we've beaten the market by buying the right companies at the right prices and letting the market move as it may. Your chance to invest rationally in a crash-prone market starts here.

This article was first published on April 27, 2007. It has been updated.

At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Microsoft. After its fall, Microsoft became an Inside Value selection. OSI is a former Inside Value recommendation. The Fool has a disclosure policy.