What to Do in a Down Market

Just about every company on the public markets has slid over the past month, and the recent decline has many investors worried about the future of their stock portfolios.

The hurt has been widespread, although the technology-laden Nasdaq and the small-cap Russell 2000 have taken the biggest hit. Also, while Dow Jones and S&P 500 companies have plunged, they are more likely to have dividends to ease some of the pain.

The table doesn't tell the whole story, though -- individual companies can fall by a much greater percentage. Spare a thought for shareholders of NeurocrineBiosciences (NASDAQ:NBIX), which has dropped from more than $60 in late April to around $11 today. Neurocrine's downfall had more to do with mixed results from the FDA than the market's slide, but it does highlight the risks involved with smaller companies (Neurocrine is capitalized at $400 million). The company's troubles stem from a non-approvable letter for the highest (and expected to be most profitable) dose for Indiplon, a sleep drug developed in partnership with Pfizer (NYSE:PFE). Now Pfizer has ended its involvement, so Neurocrine has to go it alone.

Be a contrarian
Most investors are in stocks because of they provide long-term superior returns. But very few of us feel comfortable as shareholders when faced with a market downturn or "correction," let alone a drop of Neurocrine's magnitude.

It may sound odd, but I'm actually relieved that the market is taking a breather and offering better bargains for investors. As a long-term investor, I can contribute more cash to my stock investments at times like these. It's not possible to pick the bottom price for any company, but as long as I remain confident in my original valuation, I'm not going to be panicked out of my investments -- I may even buy more. As famed Legg Mason fund manager Bill Miller said, "Lowest average cost wins."

What to do
As a value investor, I believe that down markets can be the perfect time to buy -- as long as you can avoid the emotion of a falling market and be patient.

Here are five other things that will help protect your portfolio against the worst a bear market has to offer:

1. Diligently evaluate the holdings in your portfolio. If you have a speculative high-flier or hot-stock party tip you heard about at your neighbor's barbecue, consider selling. Those companies -- with no cash, no dividends, and tons of hype -- are the first to sink and last to recover.
   
   
2. Get rid of the glamour companies that everyone is buying -- they are perpetually overvalued. For every Microsoft (NASDAQ:MSFT) that exceeds the hype, there are literally hundreds of KrispyKreme Doughnuts (NYSE:KKD) or DHB Industries -- stocks that fail to live up to the market's high expectations. So unless you're a stock-picking rock star (like my colleague, Fool co-founder David Gardner), stay away from high-priced Hollywood.
   
   
3. Get rid of your dogs. And by dogs, I don't mean stocks that may not have appreciated in price for a long time -- those may actually be a value now. Rather, dump those businesses whose fundamentals are deteriorating and are unlikely to improve. In other words, don't hold stocks for sentimental reasons.
   
   
4. Now that you've sold your glamour stocks, party tips, and dogs, you hopefully have some cash left over -- but don't be in a hurry to reinvest it all at once. Remember, investing is a marathon, not a sprint. There is nothing wrong with holding cash.
   
   
5. Sometimes, the best place to invest is in the stocks you already own, particularly if they, too have been caught in the market mudslide. Check the valuations and see whether adding to an existing holding is appropriate.

Chicken soup for the bear market
Sideways or even down markets can last for a considerable time, particularly if we see more indicators of a forthcoming economic recession. Yet this is no reason to get out of stocks. On the contrary, a market like this is an excellent time to go hunting for undervalued equities. And if this environment spooks you, just stick to companies whose products or services are virtual necessities and/or branded commodities -- as long as they're trading at good prices. Current candidates include health-care behemoth Johnson & Johnson (NYSE:JNJ), snack food and soda giant PepsiCo (NYSE:PEP), and consumer products king Procter & Gamble (NYSE:PG).

To wit, many U.S. large caps are now trading at lower price multiples than at any time in the past five to seven years, and I would particularly recommend taking a close look at those with at least 50% of revenues from international sales. That broad revenue diversification can act as a partial hedge against a further weakening of the U.S. dollar.

The Foolish bottom line
Whatever you do, don't stop investing altogether, as many folks did after the Nasdaq crash of a few years ago. They consequently missed out on the great returns from 2003 to 2005. Abandon emotion, study history, and make sure you stick to your investing strategy for the long term -- in bull and bear markets alike.

Philip Durell is the advisor/analyst of Motley Fool Inside Value , the Fool newsletter service devoted to practicing the ancient art of value investing. You can see Philip's favorite value stocks for free with a 30-day, no-obligation trial. Inside Value picks are beating the S&P 500 by nearly three percentage points since inception. Click here to learn more.

Philip owns shares of Microsoft. Microsoft and Pfizer are Inside Value picks. Johnson & Johnson is an Income Investor pick. The Fool has a disclosure policy.