With hurricane season upon us, the Fool wants you to be ready for anything. We've got lots of useful advice to help you prepare in case disaster strikes.
It's not too hard to find stocks that will go up during a bull market, just as it's not too hard to float along with the current in a quiet river. Likewise, it takes little work to find stocks that are on a great growth tear. A quick glance at today's Wall Street Journal shows me that since the beginning of the year, Amazon.com (Nasdaq: AMZN ) is up more than 83%, Apple Computer (Nasdaq: AAPL ) has risen about 42%, and National Oilwell Varco's (NYSE: NOV ) share price has increased by around 75%.
Hopping on any of those companies' river rafts might result in good returns -- for a while. But what happens when the market's weather turns stormy? Sure, true grinding bear markets like the one that began this decade are rare -- but they happen. Like hurricanes, marketwide corrections of 10% or more are regular events, and those corrections often hit overbought growth stocks disproportionately hard. If you're investing for the long term, a flimsy summer shack in Key Largo probably isn't the best way to go, even if the view is stunning. You need something sturdier.
Enter Benjamin Graham
What's the key to identifying sturdy stocks? A classic concept: looking for a margin of safety. Simply put, a margin of safety is the difference between a stock's current intrinsic value and its selling price -- assuming the latter is lower than the former. As Foolish writer Richard Gibbons said last year, the margin of safety "is the most important concept from the finest book on investing ever written, Benjamin Graham's The Intelligent Investor." (If you've never read it, go get it today -- trust me.)
One of Graham's great achievements was recognizing that, while stock prices can be all over the place in the near term, over the long haul they usually find their way toward the company's intrinsic value. This is classic value investing: If you can buy a stock at a discount, there's a pretty good chance you'll profit handsomely over time -- and you're less likely to get blown over when Hurricane Correction hits shore.
Finding stocks on sale
There are lots of ways to find good companies trading at a discount. One of the simplest and most time-honored is to keep an eye on the business media, looking for stories about established companies in solid businesses that are going through a rough period. Early in 2000, for example, Altria Group's (NYSE: MO ) stock price was in the weeds, thanks to more than a year of harsh publicity arising from lawsuits and congressional hearings attacking the cigarette industry. Despite the strong bull market of the late 1990s, Altria's stock price had fallen from a high near $60 in late 1998 to a low of $18.94 in February 2000. Yet the underlying business fundamentals remained pretty sound, and the smart investors who bought around $20 saw a 150% gain over the next two years -- right through the worst of the bear market.
What's it really worth?
Once you've found a few stocks that seem to be on sale, you'll need to estimate the true value. Figuring out what a company is really worth is an imperfect art, but the discounted cash flow (DCF) method is a time-tested way to generate a reasonable estimate. It's not without flaws, but Fool David Meier's excellent article from a couple of years ago on the methodology and its pros and cons is a good place to start. As the name implies, the DCF formula looks at the company's likely future cash flows and discounts them to generate a present value.
If the math seems daunting, never fear -- the Motley Fool Inside Value newsletter has an easy-to-use DCF calculator here. (It's for subscribers only, but help yourself to a free trial for 30 days of full access.) The calculator makes it simple to determine whether your buy candidates have worthwhile margins of safety. And while you're logged in, take a look around -- Fool value guru Philip Durell and his team of analysts have identified some great value candidates that stand an excellent chance of weathering the market's next Katrina in style.
Fool contributor John Rosevear, who wishes he'd bought MO in 2000, owns shares of Apple, but does not own any of the other stocks mentioned in this article. Amazon is a Stock Advisor recommendation. The Motley Fool has a disclosure policy.