Stock bargains: 5 tips to protect against falling knives

September 9, 2011

For bargain-hunters, identifying stocks in this struggling market might seem like an easy layup. Some prominent companies are languishing in the 99-cent bin, trading at seemingly laughable price-earnings ratios.

Consider Hewlett-Packard, on offer for a current P/E of 5.7. Then there’s BP at 5.9, Capital One at 5.8, Gannett (GCI) at 4.95 and Hartford Financial at five.

In normal times, it would be a no-brainer to load up your shopping cart. But these are hardly normal times, and there can be very good reasons why companies might be trading at such low valuations. As any Bear Stearns or AIG shareholder can tell you, it’s a tricky proposition to – as the investing saying goes – “catch a falling knife”.

That’s what has investors like Michael Gleason paralyzed. Gleason, an American TV producer who lives in London, would like to put more money to work – but the panicked gyrations of the markets don’t give him any confidence. “I’ve gone on hold lately, because volatility has gotten a bit worrying,” says Gleason, 57. “Maybe it’s better to stay out then to get out.”

And there’s the dilemma of every deep-value investor: How to decide when to take that risk, and make potentially the best pick of your investing lifetime instead of the worst. Sometimes it’s a very fine line. Could embattled Societe Generale bounce back smartly, for instance, or could it go down in flames like Lehman Brothers?

“Three years ago investors started catching falling knives, and got badly bloodied,” recalls Hank Smith, chief investment officer of equities at Radnor, Pennsylvania-based Haverford Investments, which has $6.5 billion under management. “Even though they were doing all the things they were supposed to be doing, like buying on dips. But there are a few ways to avoid the falling knife, both on a macro and a stock-by-stock basis.”

The trick is to separate those stocks that are merely beaten up, from those that may be down for the count. A few key criteria to keep in mind:

Look for yield support
A stock will be less likely to crash and burn if it has some appeal to dividend-hungry investors. That’s why Jim Barrow, who manages Vanguard funds like Windsor II and Selected Value, has snapped up names like AT&T, Johnson & Johnson, and Texas utility CenterPoint Energy. “If you have a strong company with a five or six percent yield, how much lower can it really go?” asks Barrow. “That’s one of the key things we look at.”

Stay away from Europe for now
Real gamblers might be attracted to the rock-bottom valuations of European firms, but it’s just too much of a risk, says Barrow. With the prospect of sovereign defaults cropping up from multiple locations like Greece, Portugal and Ireland, we haven’t witnessed the Eurozone endgame yet. In the meantime, there’s no sense putting yourself in harm’s way. “I wouldn’t go out on a limb,” says Barrow. “We still don’t know how low Europe can go.”

Steer clear of banks
Financials may have made some strides in cleaning up their balance sheets since the meltdown of 2008. But they’re not there yet, says Smith. Many are still loaded down with assets that are difficult to value and trade, which could lead to the same mark-to-market problems with banks and insurance companies we saw before. That means cautious investors should give them a pass.

Opt for growth
A tech giant like a Hewlett-Packard might seem like a steal, lurching near its 52-week lows. But as it looks to shed many of its business lines, and focus on the software-and-services niche that still only generates a small slice of its revenue, Hank Smith is glad he sold his firm’s position months ago. Instead, look for companies with encouraging growth strategies, along with healthy cash flow, exposure to emerging economies, and low levels of debt.

Defense wins championships
If it’s downside risk you’re most worried about, then simply stick to traditional defensive sectors like utilities, telecom, consumer staples and pharmaceuticals. Stocks like Diageo or Philip Morris, which Barrow owns, aren’t going anywhere anytime soon. “Demand for those things doesn’t change,” he says. “Even if things get real bad.”

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Look at BPL, great dividend, strong performer.

Posted by 2cartalkers | Report as abusive