Riding Out a Financial Tsunami

With hurricane season upon us, the Fool wants you to be ready for anything. We've got lots of useful advice to help you prepare in case disaster strikes.

Investing in some stocks will make you feel like a professional surfer. Other stocks will make your worst wipeout seem like a ride in a water park.

One company, e-commerce provider Digital River (NASDAQ:DRIV), is a good example of both of these phenomena. It has a stock chart that resembles waves on the ocean. After each trough, though, the peaks get higher and higher.

I first bought shares of Digital River at around $20 in February 2003 and watched them slowly stalk higher until they hit $30 in October, only to fall back to the low $20s again the following year. The stock once again broke $30, fell back, and rose again to over $40 a share. Having since gone as high as $60 a share, it now trades under $50 once again.

This has happened on several occasions: advance, retreat, advance further. It's a pattern that's repeated itself in the broader markets too.

Triggering a tidal wave
Earlier this year, world markets were rattled by the 9% drop in China's Shanghai index. Stocks everywhere plunged, including a 431-point Dow drop here in the U.S. As panicked as investors might have been, stocks recovered, Chinese markets are still in the grip of a galloping bull, and the Dow has regularly set new highs. It seems a timeless phenomenon: stocks rise, stocks fall, and they rise once again.

While there are certain calming effects such restorative actions can have, each jolt sends out new aftershocks: is it the end of the advance this time? Will this quake send out the tremors that unleash the fury of a tsunami on our stocks?

The truth is that we can't know for sure. We might always end up with a JDS Uniphase (NASDAQ:JDSU) or Lucent (NYSE:LU), both of which are former market favorites but today trade at a tiny fraction of their former prices.

Rising above the tide
What we can do is carefully choose our stocks. The best companies should be able to weather most storms. They may fall for a time -- many times economic events cause markets to pull back, regardless of the particular strength of individual companies -- but they'll bounce back.

So how do we find stocks that run with the tide while also steeling ourselves for the inevitable waves that break on the shoals?

As I said, find good companies. That means businesses that have strong leaders with a stake in the company, clean balance sheets, and good growth opportunities. Are the industries competitive? Are there "moats" which might prevent competitors from easily entering into the market? Does the company have purchasing power or buying power?

These are all questions to consider when evaluating a company before you buy and afterwards too. Notice the one thing that wasn't mentioned was the stock's price. I won't deny that the cost of a stock is important. Valuation can save you from buying at the top like I did when I purchased JDS Uniphase at around $150 a share.

But as a component of whether your stock is a good, long-term investment, the daily price fluctuations are inconsequential. They have absolutely no bearing on whether a company is a good business.

A hole in our boat?
One of the things that sinks us as investors is constantly checking the price of our stocks. When it goes up we're euphoric; when it's off we get depressed. If we could just ignore the daily price swings in our stocks, we would stay afloat during the tidal waves that seek to drown us.

For example, these stocks have had some pretty significant changes in their price recently. Over the past three years, these companies reached high points only to come crashing back down like waves on the shore. Yet they rose to even greater heights afterwards.

Had you focused only on the price of the stock and gotten all jittery when it pulled back, you would have missed out on wonderful opportunities.

As investors, it's tough not to check on our stock prices constantly. It's even harder not to let it influence our buy and sell decisions. But a stock's price doesn't necessarily equate to whether it's a good or bad company. It simply reflects what Mr. Market is willing to sell or buy it for at any particular point in time. Although we can use our knowledge of the business to determine whether the price is dear or discounted, the price tells us little about whether a stock still has long-term potential.

Ride the waves
When a tsunami hits our stocks -- and it will at some time or another -- being prepared for it will help you ride it out. That means first finding companies that have solid financials, good managers, and a firm place in their industry. With that knowledge we'll be able to surf the inevitable dips that occur without fear of selling out too soon.

Baidu is a recommendation of Motley Fool Rule Breakers, where a 30-day trial subscription can help you find the stocks that will weather the storm.

Fool contributor Rich Duprey does not have a financial position in any of the stocks mentioned in this article. You can see his holdings here. The Motley Fool has a disclosure policy.