Five tips for buying stocks in bad times

WEEKEND INVESTOR
How to outsmart a not-so-average bear
Five tips for buying stocks in bad times

By Jonathan Burton, MarketWatch
Last update: 7:01 p.m. EDT Oct. 17, 2008

SAN FRANCISCO (MarketWatch) -- You survived the stock-market crash of 2008. Congratulations. Now comes the hard part: Buying stocks and mutual funds that can survive -- and even thrive -- in the bear market.

Buying in a bear market? That's what Warren Buffett is doing. The famed investor was blunt about why: "Be fearful when others are greedy, and be greedy when others are fearful," he wrote in an opinion piece Friday in The New York Times. "Bad news is an investor's best friend," he added. "It lets you buy a slice of America's future at a marked-down price." Read Buffett's editorial.

The key, as always, is what you buy and how patient you are. Buffett isn't banking on a quick turnaround; he knows that patience is rewarded. You can average in to stocks over time -- there's no reason to back up the truck. Markets are bracing for another shock: the specter of the first consumer-led recession in almost two decades.

"This volatility is signaling the end of an era," said Rich Bernstein, chief investment strategist at Merrill Lynch. "If you're picking stocks or looking for a fund, the characteristics you want are the ability to continue to enhance shareholder value. Think of it in terms of companies that are self-funding. Look for companies that have excess cash flow."

Let that be your bear-market investing guide. You want an investment portfolio of high-quality stocks and mutual funds that not only can weather this economic storm but come through it stronger.

That naturally steers you to traditionally defensive consumer staples and health-care companies, but don't limit yourself. There will be opportunities in other sectors, but the new leaders, regardless of their business, will demonstrate the financial strength and self-sufficiency to flourish in what will be an increasingly Darwinian market.

So think like an acquirer; think like Buffett. Keep the following five criteria uppermost in mind when you evaluate a stock or the companies in a fund's portfolio:

1. Free cash flow
Free cash flow is essentially a company's budget surplus. Excess cash -- not earnings -- is for many investors the true measure of a company's flexibility because unlike earnings, cash flow is tough to fudge with accounting tricks.

"Look for strong and growing free cash flow," said Rob McIver, co-manager of Jensen Portfolio (JENSX ) . "Cash flow is harder to manipulate than earnings per share."

To calculate free cash flow, take net income plus amortization and depreciation, minus changes in working capital and capital expenditures. Companies with excess cash have options. They can invest in the business or make acquisitions, and give investors a boost by increasing dividend payments and buying back shares.

Many of the 28 stocks in the Jensen fund are large-cap consumer goods and health care companies fitting this bill. Top holdings as of Sept. 30 included medical-device giant Stryker Corp. (SYK) , pharmaceutical leader Abbott Laboratories (ABT) and consumer products titan Procter & Gamble Co. (PG) . The fund also has a newer position in software developer Cognizant Technology Solutions (CTSH) .

Said McIver: "There's a place in everyone's portfolio for high-quality companies where predictability and sustainability of earnings is valued."

2. Little or no debt

The most profitable areas for much of this decade -- real estate, energy, financials, commodities, emerging markets -- all benefited from cheap and easy credit. Now credit is not readily available and not so cheap. Accordingly, credit-sensitive sectors are underperforming.

"Companies that are levered or need to tap the capital markets are going to struggle in terms of being able to get financing at a reasonable price -- or at all," said John Buckingham, editor of The Prudent Speculator newsletter and manager of the Al Frank Fund (VALUX) .

Concentrate on companies that can finance their own growth and have low debt as a percentage of total capital. Organic growth, as opposed to growth through acquisition, is also crucial.
"Focus on balance sheet strength," Buckingham said. "We like Microsoft (MSFT) because it doesn't need to tap the capital markets." Big blue-chip technology companies such as Cisco Systems Inc. (CSCO) and Oracle Corp. (ORCL) "are excellent places for investors," he added.

In a market where cash is king and earnings predictability is paramount, Buckingham is also bullish on big pharmaceutical companies including GlaxoSmithKline Plc (GSK ) and Merck & Co. (MRK) and health insurers Aetna Inc. (AET) and Humana Inc. (HUM)

"The important thing," Buckingham said, "is does the company have the ability to navigate the difficult environment we're in or does it have to go to the markets for capital, and the markets are not exactly friendly right now."

3. Strong market share

Companies involved in basic businesses with a national or global footprint, or that help other companies be more productive have a competitive advantage in a miserly market. Marshall Kaplan, senior equity strategist with Smith Barney Private Client Investment Strategy, uses the example of oil service companies that can charge a premium for extracting oil and gas, or technology companies that make it easier to process data.

"Ask yourself, is it a viable franchise?" Kaplan said "Are you talking about products and services that are going to be needed not for brief periods but over the long term? Is the quality of earnings there? You've got to make sure you're in a situation where the business can be maintained at levels that are conducive to growth."

Stocks on Smith Barney's recommended list that meet this criteria include Apple Inc. (AAPL) , ConAgra Foods Inc. (CAG) , Johnson & Johnson (JNJ) , Kimberly-Clark Corp. (KMB) and National Oilwell Varco Inc. (NOV)

"It's tough for the individual investor to keep his or her head about them in a market like this," Kaplan said. "These types of names create a stronger level of support. The days of buy-and-hold, one-decision stocks are gone, but you could have a longer holding period in the names with these characteristics."

4. Solid management

Companies in top financial shape have management that's proactive and capable.

"Honorable," is how McIver, the Jensen fund manager, puts it.

"Understand what creates and what destroys shareholder value," he said. "You can't run a company from quarter to quarter to meet earnings targets. You have to make long-term decisions and capital expenditure decisions that will reap rewards."

The Jensen fund won't invest in a company until the managers visit executives on their home turf. Moreover, these corporate chieftains must have delivered return on equity -- net income divided by shareholders' equity -- of at least 15% annually on average for 10 consecutive years. One slip, and the stock is booted from the portfolio.

"By knowing the companies well, we can minimize business risk," he said.

5. Attractive valuation

Investors have tossed out stocks in panic, including those with strong fundamentals. Market sentiment is mired somewhere between despondency and ye of little faith.

But many professionals are taking a page from Buffett. "I'm looking for stocks that are already cheap," said Tom Forester, manager of Forester Value Fund (FVALX ) , which counts consumer goods leaders H.J. Heinz Co. (HNZ) , Kraft Foods Inc. (KFT) and Johnson & Johnson among its top holdings. "They tend to have a lot less downside, but they also have plenty of upside potential."

He's also finding bargains in technology. "I'll buy Microsoft at 12 times earnings," Forester said. "For a tech stock it's very cheap. I like the cash, the stock buybacks, and revenue streams are steady."

Buckingham's picks include General Electric (GE ) , United Technologies (UTX) and IBM (IBM) . "There's a lot of opportunity in large-cap stocks right now," he said, "and arguably you've got a greater margin of safety."

In this market, investors will need the margin of safety that a low price brings. The crash was just the end of the beginning. Now comes what could be many months of head-fakes and hopeful rallies that wind up in dead ends. You'll be Charlie Brown charging the football with head held high, only to land flat on your back.

While it won't make the challenges any easier, take to heart what veteran stock analyst Bob Farrell noted in his iconic 10 "Market Rules to Remember": Bear markets, he wrote, have three stages -- "sharp down, reflexive rebound, and a drawn-out fundamental downtrend." See related story.

Where it stops, nobody knows, but a portfolio with strong defensive stocks stands a fighting chance.

Jonathan Burton is an assistant personal finance editor for MarketWatch, based in San Francisco.

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