I don't know what I hate more -- that the market goes down way faster than it goes up, wiping out five months of profit in only five weeks, or that the fall, with its constant down days, seems to be interminable. It's more fun than a boot to the head. (But just barely so.)
Yet one day, the bottom will arrive, and there will be another huge rally. The key is to position your portfolio to maximize the upside when it arrives. To this end, I have three suggestions.
1. Don't panic
Emotions can prevent otherwise savvy investors from making money in the market. When things are going poorly, we tend to want to hide in a corner, crawl up in a little ball, and whimper. And while I've found that whimpering can be a very effective strategy during an apocalypse, it's a poor investing technique. Dumping your shares in a panic will often mean that you're selling precisely when you should be buying -- when prices are low.
The best way to keep your emotions in check is to have confidence in the value of the stocks that you own. After all, if you're certain that a stock you own is worth at least $40 per share, it won't matter so much if shares temporarily fall from $35 to $25. In fact, you may see it as a major buying opportunity.
How can you know the value of your stocks? One way is based on the company's net asset value -- the amount of money you'd have if you liquidated all the company's assets. This is an appropriate valuation technique for real estate investment trusts (REITs) such as Equity Office Properties (NYSE:EOP) or Simon Property Group (NYSE:SPG). Or, if you're looking at a business whose value is primarily a function of its future earnings, like Wal-Mart (NYSE:WMT) or Wrigley (NYSE:WWY), you can work out the stock's intrinsic value using a discounted cash flow calculation. (Our Inside Value newsletter has a DCF calculator -- available here for subscribers -- that can help you perform the math. If you're not a subscriber, a guest pass will get you access.)
As long as you're correct about the stock's value, you'll be fine over the long term. That's one reason why you should always try to buy stocks below their fair value.
2. Admit your mistakes
However, don't use "I'm not panicking" as an excuse to not acknowledge mistakes. If you bought a stock simply because it was going up -- generally a terrible investment strategy -- no intrinsic value-safety net will cushion its fall. Even if the stock was trading below your estimate of its fair value when you bought it, things may have changed. When the bubble popped, Amazon.com (NASDAQ:AMZN) proved that its growth projections were overly optimistic. Its revenue growth rate fell dramatically, and investors abandoned the stock.
If you can avoid optimistic mistakes, you'll conserve cash. And in the best-case scenario, you can swoop in when other investors have abandoned a decent company like Amazon and purchase shares when they are dirt cheap. Since the end of 2001, for example, Amazon has returned about 150%.
3. Upgrade your portfolio
The great thing about bear markets -- and yes, there is at least one great thing -- is that investors tend to sell indiscriminately. Companies with solid competitive positions such as Nike (NYSE:NKE) will sell off like they're speculative equities. And when these superior companies get undervalued, it may make sense to add them to your portfolio and reduce your exposure to more speculative ideas.
For instance, Stride Rite (NYSE:SRR) is a footwear manufacturer that's been around since 1919. It makes great children's shoes -- my 2-year-old son loves his -- and its adult brands of Saucony and Tommy Hilfiger are well known. It's trading at a reasonable price-to-earnings ratio of 15 with a projected annual growth rate of 13.5%, and a manageable amount of debt. Not great, but not wildly overpriced either.
Now look at Nike. It started in athletic footwear, and grew relentlessly from there, fending off all competitors to become the biggest name in athletic apparel. Nike's brands are definitely stronger than Stride Rite's -- it's hard to find a sporting event where you don't see Nike's swoosh logo. It has a big pile of $1.5 billion in net cash on its balance sheet. It has better growth estimates and less risk than Stride Rite. Yet it's trading at a cheaper multiple. All things considered, though Stride Rite isn't bad, now seems like a great time to upgrade from Stride Rite to Nike.
Remember, bears can smell fear
Of course, you should be trying to buy superior stocks at cheap prices even when the market isn't falling. However, a bear market tends to cloud the issues, so it's particularly important to stick to the strategy during bad times. If you're looking for great companies trading below their fair value -- the ones most likely to outperform during a bear market -- you should check out our Inside Value newsletter. You can get a free one-month pass here.
This article was originally published on July 6, 2006. It has been updated.
Fool contributor Richard Gibbons was thinking of recommending "when in panic, fear, or doubt, run in circles, scream, and shout," but didn't think it would get by his editor. Richard does not have a position in any security discussed in this article. Wal-Mart is an Inside Value recommendation. Amazon.com is a Stock Advisor recommendation. Wrigley is an Income Investor recommendation. The Fool has adisclosure policy.
