The Manual of Ideas'  Instablog

We recently revisited the stocks recommended in Downside Protection Report since the inaugural issue last December. Two things stood out: First, we’ve done quite well to date, though the short measurement period means we’re not entitled to draw any strong conclusions. Second, nearly all of the stocks discussed in previous issues, including EchoStar (SATS), Gravity (GRVY), Greenlight Re (GLRE), Harvest Natural Resources (HNR), K-Swiss (KSWS), and Sierra Wireless (SWIR), had an uncertain outlook and other fundamental concerns at the time we recommended them. They were certainly no “blue chips.” So how come those were the companies we judged to have the strongest downside protection?

In thinking about this question, we tried to think of “blue chips” that have avoided major hiccups for decades or longer. Citigroup (C) didn’t make the list. Neither did Merrill Lynch, Wachovia, General Motors (GM), AIG (AIG), Freddie Mac (FRE), the major newspaper companies or the major airlines. Even companies like AT&T (T), American Express (AXP), Moody’s (MCO), McGraw-Hill (MHP), and General Electric (GE) have been tarnished. Very few blue chips have provided the kind of downside protection investors have come to expect of them over the decades. Coca-Cola (KO) might be one of those blue chips. Wal-Mart (WMT) might be another.

If almost every blue chip sooner or later falters, what’s an investor to do? The first part of this question hides the answer: If we assume that every company will hit a snag at some point, perhaps we should invest after the snag rather than before it. Most of our past picks have this in common: They are companies that have “blown up,” causing a sharp drop in their stock price. While many of those companies are irreparably damaged, some of them will eventually recover. We try to find companies that are already showing signs of recovery but whose stock prices have not yet responded appropriately. As a result, the companies tend to be dramatically undervalued, providing us with a large “margin of safety.”

Another attribute shared by our recommended companies has been their strong financial position. Most stock market participants are notorious for being “income statement investors” — they buy companies beating analyst estimates and growing earnings. When earnings falter, many investors sell the stocks regardless of the balance sheet. By contrast, we view a company’s financial position as a major anchor of value and one of the surest ways to protect ourselves on the downside.

Disclosure: Long GRVY, HNR.