The stock market crash following the Internet bubble destroyed portfolios and dreams. The Nasdaq alone fell from 5,000 to below 1,200 -- a nearly 80% decline. And that's only the average. Many stocks became essentially worthless. The tragedy wasn't in the numbers, though -- it was in the effect these losses had on people. Many investors were completely wiped out, losing money they'd been saving for years.
This really isn't the sort of pain you want to experience firsthand. That's why it makes sense for all investors to have a portfolio that is prepared for lean times. If a terrible day ever comes, you'll want to make sure you suffer only a flesh wound, not decapitation.
At Motley Fool Inside Value, we specialize in identifying stocks that not only outperform on the upside but also can survive a crash relatively unscathed.
Diversify, now
Investors with technology-focused portfolios suffered the most a few years ago. There was almost nowhere in the sector to hide, with even the strongest companies suffering huge declines. Hewlett-Packard
The moral of the story isn't that technology companies are risky, but rather that diversification is a key component of a crash-resistant portfolio. While tech has been dreadful, the Vanguard REIT Index has more than doubled since 2000, and energy stocks have had outstanding returns recently. A diversified portfolio that included technology, REITs, and oil would have prospered. Furthermore, diversification ensures that you get the full benefit of your stock selection skills. The crash has shown that it's no condolence identifying the best-performing stocks in the worst-performing sector. Being the best of the losers doesn't make you a winner. But if you pick the best of each sector, you'll do quite well.
The Inside Value newsletter follows this diversification philosophy by recommending stocks in sectors ranging from technology to financial and with market caps from $1 billion to $300 billion. Even our selection strategies vary -- we'll search for everything from undervalued growth stocks to cheap businesses poised for a rebound after suffering downturns or temporary bad news.
Buy cash
The problem with the companies that fell the most when the bubble burst was that they had neat ideas but didn't actually make any money. Even some of the most popular companies had this problem, such as RealNetworks
Unprofitable companies have little flexibility in bad business climates and tend to do poorly in bear markets. In a panic, investors aren't buying dreams. They're sticking with consistent cash machines -- such as steady, dividend-paying blue chips Wal-Mart
At Inside Value, every single pick is a real business that makes piles of cash and has a significant competitive advantage. Consequently, these companies position themselves well in case of a bear market or a worst-case-scenario market crash.
Be skeptical
One of the best ways to guard your portfolio against a market crash is by maintaining a healthy level of skepticism. Wall Street isn't a charity. It's a bunch of businesses focused on making money for themselves. Helping small investors make a profit is Item No. 382 on the list of Wall Street priorities, immediately after ensuring that the new assistant knows exactly the right amount of Splenda to put in the morning coffee.
Be skeptical of analyst forecasts, whether it's a prediction that oil will hit $110, or that InfoSpace
Instead, rather than trusting the analysts, make sure that you understand the companies you're buying. Understand what risks each business faces and what competitive advantages will help the company overcome hurdles. Be particularly wary of high growth estimates, because analysts tend to be optimistic, and high growth is difficult to sustain. If the company fails to achieve overly ambitious growth estimates, the stock will be hammered. Finally, buy a stock only if, after conservative analysis, the company is trading at a bargain price. Stocks tend to return to their intrinsic value, so buying below that value provides significant protection in a crash.
We follow these techniques at Inside Value by performing our own research, starting with a thorough understanding of the company. As part of each recommendation, we not only describe what the company does, we also discuss the competitive landscape and possible risks. Finally, we recommend only stocks that are trading at dirt cheap prices. On average, our picks last year were recommended at prices equal to 72% of their intrinsic value. There is some variance, of course. At the time of this writing, one pick was trading at only 60% of its intrinsic value.
So while a crash will have some negative effects on any portfolio, a few carefully chosen strategies can help you avoid the worst and give you the opportunity for big gains along the way. If you're interested in reading our recommendations, we offer a free, no-risk 30-day trial. A trial gives you access to current and past issues, a discounted cash flow calculator for calculating the intrinsic value of any stock, dedicated discussion boards, and three special Inside Value reports. There is no obligation to subscribe, and you may just figure out a blueprint for a bear-resistant portfolio.
This article was originally published on Sept. 28, 2005. It has been updated.
Richard Gibbons is scared of stock market crashes, large flying objects, and eerie music. He does not have a position in any of the companies mentioned in this article. The Motley Fool has a disclosure policy .
