Make no mistake about it -- this is still a very scary market. While the CBOE Volatility Index (a.k.a. the "investor fear gauge") has fallen sharply from its record highs in October, it still remains near 30, which, on a historical scale, still indicates investor anxiety.
Last fall, I advocated the importance of keeping a long-term focus and strategically avoiding the media blitz of bad news. But keeping your cool in this mess doesn't apply only to panic selling, but also to panic buying.
Just because a number of stocks, such as drive-in restaurateur Sonic, have fallen considerably in recent weeks, that doesn't mean they've reached the point of maximum pessimism and are worthy of buying whole-hog right now. In fact, I would argue that Sonic -- despite its delicious drink menu -- is one "value" to avoid in this market.
You don't own me
For one, Sonic relies heavily on debt to fuel its respective operations. As of August 2008 (the end of its last fiscal year), it was capitalized with just over 100% debt and negative equity. Simply put, debtholders, not common stockholders, virtually run the show at the company these days. Those debtholders care most about getting their money back, plus interest; they don't necessarily have any interest in long-term earnings growth.
This brief analysis doesn't even consider Sonic's intense competitive landscape as it competes with the larger, more efficiently-run and less-leveraged Chipotle Mexican Grill
While there's always a remote chance that Sonic will restore balance sheet health, I wouldn't bet hard-earned money on it. There's simply easier money to be made in the market.
Like how?
When the market is scared and the debt markets are unpredictable, it pays to start your search by looking for superior companies whose stocks may have been unfairly punished. In short, this means seeking out stocks with these qualities:
- More than 40% off their 52-week high
- Manageable debt
- Return on equity above 10%
- Positive free cash flow
- Cash in the bank
Here are some examples:
|
Company |
% Below |
Return on Equity |
|---|---|---|
|
Southern Copper |
44% |
25% |
|
Schlumberger |
51% |
30% |
|
General Dynamics |
41% |
23% |
|
Flowserve |
51% |
32% |
|
Eaton |
50% |
13% |
Source: Capital IQ, a division of Standard and Poor's.
Like Sonic, these companies have been beaten down in this market, but their futures are much brighter. Since they generate enough cash by themselves, they don't rely heavily on the debt markets to maintain operations, and they can remain focused on shareholder interests.
Buy them now?
Even though you now know which values to avoid and which ones to consider in this market, that doesn't mean you should invest all of your savings right now. Although the market has rallied in recent weeks, we may not be out of the woods just yet. Nevertheless, now is a great time to begin (or keep) adding money to great companies trading at great prices.
The last time the market was this scared of equities, as measured by the CBOE Volatility Index, was August through October 2002. During this period, Fool co-founders David and Tom Gardner picked six stocks for Motley Fool Stock Advisor that have since returned an average of more than 150%.
Cautiously investing in this market is understandable and smart, but the most important thing is to keep adding money to your portfolio. Rather than chasing potential value traps like Sonic, focus on companies with strong business models that will serve them well when the market finally comes around.
These are the types of stocks we look for at Stock Advisor. If you'd like to learn more, consider a free 30-day trial. There's no obligation to subscribe.
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This article was originally published Oct. 20, 2008. It has been updated.
Todd Wenning likes his sugar with coffee and cream. He owns no shares of any company mentioned. Chipotle Mexican Grill is a Motley Fool Rule Breakers selection. General Dynamics is a Motley Fool Inside Value pick. Buffalo Wild Wings and Chipotle are Motley Fool Hidden Gems selections. The Fool has written puts on and owns shares of Flowserve, and also owns shares of Chipotle and Buffalo Wild Wings. The Fool's disclosure policy fights for its right to party.
