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3 Reasons Bad Times In the Market Can Be Good for Growth Investing

I'm a growth investor, which is a decision I only came to after I started working at Cabot, so these reasons apply to growth investing.

Reason Number One:Bad times in the market identify winners and losers.

Corrections, whether intermediate-term or full-fledged bear markets, separate the stock sheep from the stock goats very quickly. When everything's working and markets are kiting higher, investors actually have to work to lose money. And when every stock is making money, it's hard to tell whether strong fundamentals, attractive charts and sound, appealing growth stories are even necessary. Especially during big rallies and bubbles (the biggest rallies of them all), all kinds of investments work, but the corrections that follow chew up any stock that doesn't have a full set of credentials, and any investor who doesn't have a set of rules to guide them.

Why is this a good thing for you? Well, growth investing is a game of winners and losers. And by watching how stocks act during market downtrends, you can see where the real strength is. Investors with a good set of rules to follow can use negative market action to weed out portfolio losers. If markets didn't conduct a little reality check once in a while, growth investing would be a pretty dull business.

When markets flush out unsound stocks, you win.

Reason Number Two:Bad markets reward you for playing defense.

When markets are pulling stocks lower, you get a chance to follow the defensive rules that set you apart from the majority of growth investors. Having sensible rules for selling stocks is the foundation of successful growth investing, but until they're actually needed, that's all they are. It's when you actually exercise your loss limits and sell some stocks that you get the full benefit of your knowledge and discipline.

Plus, since index mutual funds are locked into holdings that parallel their benchmark indexes, they have no choice but to ride a correction all the way down. You don't have to do that.

I've said many times that being heavily in cash during a big market correction is like enjoying a drink by a warm fireplace while watching a storm through a picture window. Markets don't give you many opportunities to be self-satisfied, but that's one of them.

Reason Number Three:Bad times in the market create value.

Assuming that you've followed the rules, when a market downmove is done, you have a hoard of cash and a market filled with stocks trading at bargain prices. Growth investors don't care as much about high P/E ratios; the best growth stocks trade at high multiples, and prices increase anyway. That's just the way it is.

But growth investors appreciate a good bargain as much as anyone, and Mike Cintolo is always advising his subscribers to "buy on dips." Finding a stock that meets all the criteria for inclusion in a growth investing portfolio yet still sports a low P/E is all to the good. There's nothing that says a growth investor can't have value investors on the bandwagon as well.

As an example, here's a chart of Silicon Motion ( SIMO ), a stock that I have in the portfolio of Cabot Emerging Markets Investor. The stock trades at a very reasonable 13 times earnings, but I didn't really take that into account when I recommended it. I was more interested in the stock's run from 27 in early January to 41 last week. And I'm also happy to see that SIMO is resisting the downtrend in emerging markets stocks and chip stocks, falling a reasonable couple of points and staying nicely above its 50-day moving average. (And that's a good illustration of both Reason Number One and Reason Number Three, right there!)

As they used to say in the Ozarks, "Roof don't leak when it don't rain." And when markets are rainy, you find out a lot about which part of your roof needs attention. In growth investing, it pays to pay attention when bears are lurking.

Fortune Cookie

Here's this week's Fortune Cookie. Remember, you can always view all previous Fortune Cookies by here and Contrary Opinion buttons here.

"In all affairs, it's a healthy thing now and then to hang a question mark on the things you have taken for granted."

-Bertrand Russell

Tim's comment: In your own investments, it's a good idea, from time to time, to reexamine the prospects of those stocks you have held for a long time. Companies change, markets change, and you should at least consider changing, too.

Paul's comment: Bertrand Russell was a British mathematician, philosopher and writer (also Nobel Prize winner) who made many Brits uncomfortable during his 98-year life. He was born into a world of Victorian certainty in which the British Empire spanned the globe, and questioning things was a more radical idea than it is now. But the basic idea of examining your assumptions as an investor is just good common sense.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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