Downside protection used to be easy. Investors looking for a safe way of participating in the stock market could buy “blue chips” and sleep soundly at night. No longer. With staples such as General Motors (GM), Citigroup (C) and General Electric (GE) down anywhere from 50% to more than 80% in the past year, it’s clear that blue chips are no place to hide.
But the damage goes beyond temporary price declines. Several companies thought of as safe and stable until recently have suffered catastrophic—and, thanks to dilutive bailouts, almost certainly permanent—impairments of capital. The list includes giants American International Group (AIG), Freddie Mac (FRE) and Fannie Mae (FNM).
CEOs and directors of a subset of the largest and most widely owned American corporations engaged in stunningly irresponsible risk taking during the recent period of over-leveraging and corporate excess. As we throw out all sorts of preconceived notions about self-regulating markets, the wisdom of our “best and brightest” business leaders and the capacity of government to protect our financial system, it is also time to throw out the term “blue chip.”
Small caps are no panacea either. The Russell 2000 index of U.S. small-capitalization stocks ($905 million average and $345 million median market value) is down 39% year-to-date through December 5th. The Russell Microcap index of the smallest public companies ($275 million average and $100 million median market value) has fallen 44% during the same period.
What is a common stock investor to do, short of fleeing from the market altogether at an inopportune time, and short of resorting to strategies that involve short selling or option buying? With consistent effort and a focus on individual businesses rather than entire market segments, investors can take advantage of today’s environment by investing in companies with low fundamental downside and large upside. As Warren Buffett once advised, be ready to profit from folly rather than participate in it.