Twenty-five Rules of Investing:  1  |  2  |  3  |  4  |  5  |  6  |  7  |  8  |  9  |  10  |  11  |  12  |  13  |  14  |  15  |  16  |  17  |  18  |  19  |  20  |  21  |  22  |  23  |  24  |  25 



Buy Damaged Stocks, Not Damaged Companies



Rule 4

Let's say Wall Street is holding a sale of solid merchandise that it has to move. And let's say you take that merchandise home only to find it doesn't work, has a hole in it or is missing a key part. If we were on Main Street, of course, it wouldn't matter. There are guarantees and warranties galore on Main Street. You can take anything back.

You can't return merchandise on Wall Street and get your money back. Nope, no way.

Which is why I always say:


You have to buy damaged stocks, not damaged companies.


Sometimes these buys are easy to discern. In 1998, when Cendant (CD - news) was defrauded by the management of CUC International through a series of bogus financials, the stock went from $36 to $12 in pretty much a straight line. Was that a one-day sale that should be bought? No, that was a damaged company. It took years for Cendant to work its way back into the hearts of investors. Some say it has never recovered.

But when Eastman Chemical (EMN - news) announced a shortfall in early 2005 because of a problem — a fixable problem — at one of its facilities, that 4-point dip was a classic panic sale, one that you had to buy. The stock subsequently moved up a quick 8 points when the division recovered in the next quarter.

Sometimes, the sales on Wall Street aren't as obvious. I got snookered in 2004 thinking that Nortel's (NT - news) accounting problems were a simple sale of a damaged stock, with the company quite whole. In fact, the company was gravely damaged by an accounting fraud, and it has looked doubtful the company would ever recover.

And sometimes the sale is so steep that it looks as if something's dreadfully wrong, when really the problem is something that over the longer term will go away.

How do we know if there is something wrong with the company instead of just the stock? I think that's too complicated a question. What I like to do is develop a list of stocks I like very much, and when Wall Street holds an en masse sale, I like to step up to the plate. I particularly like to be ready when we have multiple selloffs in the stock market because of events unrelated to the stocks I want to buy, a major shortfall of an important bellwether stock, or perhaps some macro event that doesn't affect my micro-driven story.

Of course, sometimes you just have to deduce that the company's fortunes haven't really changed, and the fundamentals that triggered the selloff (either in the market or in the company) will be something that will reverse themselves shortly. But you never know. Which is, again, why I think that rule no. 3 must be obeyed. If you don't buy all the stock at once, and if you take your time, it is more likely that you won't be left holding a huge chunk of merchandise when more bad news comes around the corner.