Don't Get Caught Holding the Bag

Have you ever bought a stock simply because it was going up, and you didn't want to miss out?

If so, you were investing according to the "greater fool theory." In short: You were gambling that the stock would keep on rising, and that you'd be able to sell it later to some greater fool willing to pay an even higher price than you did.

It's a nice concept, but as the 2000 dot-com bubble and the current housing bust remind us, all bubbles collapse eventually. And if you ignore fundamentals when it comes to buying stocks, you'll get caught holding the bag.

Fortunately, there's a better way. One time-tested investing strategy teaches us that rather than being the greatest fool, we should seek to buy stocks from the greatest fool.

What goes around, comes around
The same sort of investor who buys a stock just because it's rising is likely to sell one just because it's falling. Thanks to momentum, stocks can become just as dramatically undervalued as they were overvalued.

You want to buy stocks when they're dramatically undervalued. Just check out the performance of these dot-com survivors, to see how well you could have done after momentum had pushed them all the way back down:

Company

Peak
Price

Recent
Price

Post-Peak Low

Return
From
Low

Cisco Systems (Nasdaq: CSCO  )

$82.00

$21.85

$8.12

169%

Juniper Networks (Nasdaq: JNPR  )

$244.50

$24.04

$4.15

479%

The currently falling angels
Current market momentum is punishing housing and mortgage stocks almost as severely as it did high-tech stocks just a few years back.

Company

Peak
Price

Recent
Price

Fall From
Grace

Toll Brothers (NYSE: TOL  )

$58.67

$20.70

(65%)

Centex (NYSE: CTX  )

$79.66

$23.45

(71%)

DR Horton (NYSE: DHI  )

$42.82

$15.69

(63%)

IndyMac Bancorp (NYSE: IMB  )

$50.50

$8.46

(83%)

Granted, the housing bubble may not have finished bursting. Even so, with share prices so very far below their peaks, it's probably time to start sniffing around for companies that:

  • Will almost certainly survive this mess
  • Are priced as though they won't

Because just as in any collapsing bubble, once the bottom hits, the recovery begins.

Find the true discounts
Of course, there are key differences between the last bubble and the current one. During the tech bubble, even cursory looks at companies' financial statements would have revealed just how outrageously priced they were. This time around, things are a bit trickier. The stocks getting whacked now appeared to have solid financials, but those financials were backed by assets that turned out to be worth far less than originally thought.

That's why, at Motley Fool Inside Value, we urge investors to pay attention not only to the obvious financial metrics of a company, but also to the underlying quality of those numbers. Careful research should help us keep clear of value traps, instead discovering the true discounts in the market.  

You can see the stocks we're recommending for turnaround today by joining Inside Value free for 30 days. There's no obligation to subscribe.

At the time of publication, Fool (note the capital "F") contributor and Inside Value team member Chuck Saletta did not own shares of any company mentioned in this article. The Fool has a disclosure policy.


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