There are times when sitting on your hands is a good thing. When you're sitting in a deer stand in Minnesota in November, for instance. Or for the next few days following a drunken late-night trip to the nail-polish aisle at Walgreen. (Don't ask.)
But market drops are not among those times. Refusing to buy when everyone else is frightened is a good way to set yourself up for a lifetime of subpar returns. It's also a good way to dull your investing wits. After all, it's easy to make money when everything is going up. Even my patented "Dog-o-Matic Stock-a-Tron" (Open Wall Street Journal. Put on floor. Call dog. Buy whatever dog drools on.) produces excellent returns in good times.
In contrast, coping with a wishy-washy market, or an outright bear, takes more guts and skill. But fear not, pessimistic Fool. There are varying levels of profitable pessimism to choose from. In today's climate of fear and loathing, I've been doing a little bit of all of these.
Basic pessimism:
Don't freak out. If you're new to the market, a couple of months like these can scare you away for good. First of all, keep in mind that this kind of thing happens all the time. It's not the end of the Earth, nor is it the end of your portfolio. Take a deep, cleansing breath and plan for the future.
Set aside some cash. Sure, things look bad. But they could get worse. And those of us who relish a good market shakeout respond to it by keeping plenty of the mythical "dry powder" handy -- money to spend on good companies that get thrown down along with everything else. So skip a few cups of coffee from Starbucks and consider upping your contribution to your retirement account, especially if you get an employer match. With the market in turmoil, why would anyone pass up a free 10% or 25% return on investment? Another way to get some cash ready is to do a bit of gardening in the old portfolio.
Cut flowers and pull weeds. Given our clear preference at the Fool for buying and holding good companies, this might sound like heresy, but here it is anyway: There's nothing wrong with selling stocks once in a while. A stock is not a spouse, and bailing out on a full or partial position is not the same as coming home with someone else's cologne on your collar. I'm not advocating trying to time the market, because I still don't think it can be done. That said, with good companies reporting excellent earnings and still getting brutalized by the market -- cough, Intuitive Surgical (NASDAQ:ISRG) -- I have not been shy about taking a few profits lately and looking for cheaper places to deploy the proceeds.
That's why I've recently sold some positions in companies that I still like. Late last summer and fall, there were many of these, like Chico's FAS (NYSE:CHS), that were selling at excellent discounts. I bought a few -- a bit of tech, some retail. I still believe the companies have a long way to go. But for the time being, I'm content to cut a few of these beautiful blooms and admire them rather than let them go to seed in the current, cold season. Don't be afraid to book a nice 60% gain once in a while, especially with stocks you hold in a non-taxable account.
At the same time, now may be a good time to yank a few weeds. If you have clunkers that you bought on a whim, and things aren't going well for the company, it's highly likely that these companies will get more than their fair share of the beat-down should the markets continue their downward walk. The ne'er-do-wells don't get the benefit of the doubt in times like these.
Intermediate pessimism:
Buy pre-thrashed shares. Or at least start eyeballing them. Stocks that have already had the stuffing torn out of them may already be bargain-priced and thus a lot less likely to float downward with the market's whim of the day. We have an entire newsletter, Inside Value, devoted to finding these opportunities, but scanning the actives and the 52-week-low tables will give you ideas of your own.
One that caught my eye this week is UST (NYSE:UST), a steady sin stock that I've been watching for months, hoping for a sale price. I may have gotten my wish. Shares took a 15% pounding yesterday and continue to dribble downward. Why the big cut? The firm missed analysts' quarterly estimates by a whopping $0.03, earning $0.73 per stub. It also pushed its full-year guidance downward by a dime to around $3.25 per share. This is a company with very strong historical returns on capital, assets, and equity. And its products, smokeless tobacco and wine, may not be hot growers, but they're steady, and the firm has some degree of pricing power over the tobacco line.
Another good looker is prime newspaper and media outfit Gannett (NYSE:GCI), which is trading at a 52-week low, and at a multi-year low when you evaluate shares on a price-to-earnings basis.
Look out over the water. Yet another way to reduce your exposure to fickle U.S. consumers and markets is to look overseas. My UK colleague Maynard Payton has a good idea for a value-priced UK cash cow, but you don't necessarily need to buy foreign companies to get the benefit of foreign sales. Want a piece of capitalism in China? YUM! Brands is one idea. To return to a traditional sin stock, take a look at Altria's (NYSE:MO) recent moves in Asia, including the purchase of an established Indonesian cigarette maker, as well as a rumored licensing deal to bring Marlboros into China, where there are more smokers than there are people in the United States.
Show me the muh-nay. At times like this, I become more and more interested in steady dividend payers. Lately, I've been partial to the picks that my colleague Mathew Emmert has dug up for his Income Investor newsletter. Coincidentally, over the past few months, he's been looking at some very solid foreign issues -- stuff with monopolistic advantages and steady cash earnings, like major consumer brand Unilever (NYSE:UL), or telecoms -- some of which pay dividends in the 8%-10% range. As he's fond of pointing out, the yield alone on some of these stocks is very likely to beat the broader U.S. market this year. It's tough to argue with that.
Advanced pessimism:
Go short. Let's face it, even though it might make you feel like taking a shower to be a negative Nelly, pessimism would have paid off a lot better than hopefulness over the past few months. During that time, I've looked back at several firms where I believed that things were going to turn out badly -- for instance, here, or here. I was talking about places like Martha Stewart Living Omnimedia, Ford, GM, and Navistar (NYSE:NAV), which were clearly priced beyond any success that the firm would be likely to deliver. I sure wish I'd put my money where my mouth was and shorted a few of these bloated stocks, at least through buying put options, where your risk is capped.
Let me be clear. I'm not sure I'd short any of these now. There's not much meat left on the carmakers' carcasses, and Martha's company can zip upward no matter how bad the numbers actually are. I continue to cast the hairy eyeball on Navistar, however, because it's closely tied to the (slowing) economy, its rosy promises for the future have a habit of turning sour, and it continues to suffer from an odd inability to get the math right. But there are always overstuffed equities out there. I'd start by looking for some of the zooming commodity cyclicals and heavy industries that have robust debt exposure and bloated inventory yet still defy gravity.
Options. Oh, my. Isn't this far too difficult and risky for the average investor? For a long time, the party line at the Fool has been to flog the risk of options, to the point that, on some of our boards, the mere mention of the word sends our faithful Fool followers into disdainful paroxysms. "Sheer gambling!" many exclaim. Nonsense, I say.
I don't mean to suggest that options are easy or risk-free, but, properly utilized, they provide a way of getting paid to wait for prices you're comfortable with, on both the buy and sell side, as well as a reasonable hedge against short-term market pandemonium. In a nutshell, options simply grant the buyer the (wait for it) option to buy or sell a stock at a certain price within a certain time frame. Conversely, they obligate the seller to buy or sell a stock at that price within that time frame. In practice, most options are bought and sold before any of the final calling or putting takes place. For more details, read this article, and then this primer, and this one, too, and then get back to us.... OK, up to speed? Let's go.
Covered calls. Got a stock that still trades at a frothy premium and you doubt that the market is going to send it higher in the short term, but you'd be willing to part with it for just a bit more money? Consider selling, or "writing" covered calls. (Note that writing calls for stock you don't own is wicked dangerous, and I don't recommend it at all.) An example with simple math: If your frothy stock trades at $34 per share, and you can sell calls at a strike price of $35 per share for $1 each, you pocket the premium immediately. If you have 500 shares, that's a quick $500, minus commissions. Now, if the stock is called, you'll be selling your shares for $35, but since you already got that extra buck per share, it's more like you sold for $36. If your stock takes a dip or never reaches the point where it's worth the option buyer's while to "call" it, the options expire worthless, and you keep the premium.
Puts. One of my favorite uses for puts is in place of a standard limit order to buy. By selling puts, you give the buyer the option to force you to purchase stock at a set price, say $25 a share. If you are already convinced that $25 is a screaming bargain for that company, then you might be begging someone to force you to buy it. In this case, selling puts gets you no risk and immediate payoff, the option premium. If the stock never hits your buy price, again, you pocket the commissions. In my experience, the biggest risk here is in missing out on a stock that you really would like to have owned because it was never put to you. But hey, at least you get to keep that free money.
Buying puts is similar to shorting a stock. They rise in value as the stock's price drops. This is useful in two ways. One is shorting a stock with a capped risk: You can never lose more than the value of that put option, unlike with plain vanilla shorting, where being wrong could conceivably smite you with unlimited risk.
Another decent strategy is to use puts to hedge a volatile long position. Not long ago, I bought puts on a jittery portfolio holding because I was pretty sure the short-term outlook for the stock (not the company) was toward terra firma. I had no interest in selling the stock because this is a strong outfit, and the shares could just as easily have popped up in the other direction. The answer, for me, was to buy a few contracts of put options as a hedge.
Over the span of a month, as the stock price continued to fall 18% or so, the puts increased in value well over 150%, largely offsetting the paper loss I was taking on the common shares. I sold the puts -- at the near-term bottom, it turns out, for the stock (more luck than skill, I promise you). My only "risk" was that the puts would expire worthless if the stock increased in value. But remember, this was what I really hoped would happen. The limited capital I was spending on the puts would be offset by the much larger gains I believe possible for the common stock itself over the long term.
The Foolish bottom line
You can be negative on the overall market without seeing negative in your portfolio's returns. Just keep in mind that what goes up often comes down, and vice-versa. And remember that the most successful investors of all relish sagging markets, even if it means some red in their returns. When everyone's afraid and tossing away good and bad alike, Fools ought to make like Buffett, Lynch, and the rest of our investing idols. Be smart. Be optimistic in your pessimism. Stay in the game.
For related Foolishness:
- How'd you like to get paid to wait?
- Like a rock? Sure, one that's been dropped off a tall building.
- Watch the smoke across the water.
- Look out for bugs in Martha's muffins.
Seth Jayson is hoping for even more market panic. He's not too proud to take stock picks from his colleagues at Inside Value and Income Investor , and he reminds you that you can take a free trial of either. At the time of publication, he had positions in no company mentioned here. View his stock holdings and Fool profile here. Fool rules are here.
