Now Is the Time to Upgrade Your Stocks

"This time, like all times, is a very good one, if we but know what to do with it."
-- Ralph Waldo Emerson

Ever since the market bottomed out in March 2009, we've seen what many derisively call a "junk rally": Stocks with obvious problems (debt-laden balance sheets, huge losses, etc.) have risen faster than their higher-quality brethren.

Here are three examples:

Make no mistake: The rising prices of the lower-quality stocks don't necessarily mean the stocks are any higher quality than they were before.

Office Depot, though cash-flow positive, can only dream about the profitability of Staples; Las Vegas Sands sports a riskier balance sheet despite having weaker earning power versus a not-overly-conservative-in-its-own-right Wynn; Bank of America still has a non-performing loans ratio of 3.6% (vs. 2.8% for BB&T).

It's not so much a vast improvement in operations that has moved these stocks as a market sentiment that has recovered from a feeling of utter hopelessness.  

But here's a secret about the so-called junk rally. I don't care whether you label a stock "junk" or a "blue chip." And I don't care about the amazing run-ups that have made your neighbor a killing.

I only care about the answer to one question.

That one question
When a stock doubles or triples (or more) in price, it's hard to think rationally about it. Bulls think, "How can a stock that created such fortunes be a bad investment?" Bears think, "How can a stock that rose so much be considered cheap?"

This relative valuation problem is the same trick stores play on us. When something is 50% off, we instinctively believe we're getting a bargain regardless of the absolute price. But in reality, only the absolute price matters -- either a shirt's worth $50 or it's not. It's the same thing with a stock price.

Whether a stock is downtrodden, as so many were last March, or it's coming off a huge hot streak, as many are now, we investors need to focus on one question:

Is the stock worth owning at today's prices?

How can you tell?
The first thing to realize is that no stock is a sure thing. But some stocks are less likely to leave you heartbroken than others are. The higher a company scores on these four attributes, the more you should be willing to pay for its stock:

1. Strong balance sheet.
2. History of solid profitability.
3. Sustainable competitive advantage.
4. Strong growth prospects.

But even if it scores poorly, it may be a good buy if the price is low enough. In fact, if the price is right, a "junk" stock can be more attractive than a "blue-chip" stock on a risk-adjusted basis.

The reason that stocks such as Office Depot, Las Vegas Sands, and Bank of America rose so much during the rally is that the market had beaten them down to such a low level back in March 2009. The market was driven by fear for the worst, so companies with serious bankruptcy risk were priced as such ... and then some.

A word of caution
But let's not pick nits. Just about any investment made last March has done very well. If you had the fortitude to take advantage, I offer you congratulations -- but I also offer you a warning.

With the stock market no longer priced for financial Armageddon, now is the time to look at the risk-reward profiles of all your holdings. The market has been fairly stable recently, but don't be lulled into a false sense of security.

As the ancient Roman poet Horace put it, "A heart well prepared for adversity in bad times hopes, and in good times fears for a change in fortune."

In other words, now is the time to upgrade your stocks.

Let me upgrade you
Whether your portfolio is full of "blue-chip" stocks or "junk" stocks, you must be vigilant to ensure that the current price is fair. The worse the balance sheet, profitability, competitive advantage, and growth prospects of a company, the less a stock should be worth to you. This is the case if you're newly buying a stock or just holding it in your portfolio.

I'd be remiss if I didn't give you a couple of upgrade ideas for any overvalued stocks in your portfolio. So I turned to The Motley Fool's founding brothers, David and Tom Gardner, for the stocks they like at today's prices. Both of the stocks below made the Best Buys Now list in their monthly investment service, Motley Fool Stock Advisor.

If you find a weak link or two in your portfolio, Nucor and Interactive Brokers are good research candidates to start your upgrade process. If you'd like to see all of David's and Tom's Best Buys Now (10 total), I invite you to try their Stock Advisor service free for 30 days. Click here to get started. There's no obligation to subscribe.

This article was originally published Feb. 5, 2010. It has been updated.

Anand Chokkavelu doesn't own shares of any company mentioned. Even though he used Emerson's quote, but he always believes in a Thoreau analysis. Interactive Brokers Group, Nucor, and Staples are Motley Fool Stock Advisor selections. The Motley Fool has a disclosure policy.