With the Market in Chaos, What Should Investors do Now?

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Investors are pressing the "Sell" button as fast as they can, dumping stocks that have already fallen 20% or 30% on fears they'll fall even more in the sessions to come. The current environment appears based on fear more than fact.

Indeed, the Dow Jones Industrial Average (DJIA) was merrily loping along toward the 13,000 mark just a few weeks ago, just as earnings season got underway. Since then, most companies have delivered quarterly results that could best be characterized as "decent" to "excellent." Yet the Dow has been in utter freefall, moving below 12,500 on July 27 and below 12,000 on Aug. 2. Just a few sessions later, the Dow is now below 11,500, putting us right back where we were at the start of the year.

Is it time to throw in the towel and save your funds for sunnier times? No way. In fact, history has shown that you really make money in stocks when you steadily sell into a rising market and steadily buy into a slumping market. It takes a lot of intestinal fortitude to "zig" when others "zag," but this is how the most successful investors, people like Warren Buffett and George Soros, made their fortunes. [See: " A Review of Pase Economic Downturns " from InvestingAnswers.com]

It's deja vu

For active investors, this recent selloff is quite disturbing. We're less than three years removed from the last market plunge, and many hoped such a traumatic event would only come along once every decade or two. Right about now, many are wondering if we should brace for another 2008/2009-style meltdown. After all, the downdraft that started in the summer of 2008 would continue for more than six months and the market only found a floor in March 2009.

Yet in many respects, the current selloff has little to do with the drop from three years ago. Back then, companies suddenly found themselves without access to credit as the financial system seized up, a wide range of firms carried staggering amounts of debt that they took on during headier times, and consumer spending virtually evaporated.

Recent economic data are pretty sobering as theeconomy looks to be headed for zero or even negative growth. But companies are so much stronger now, with leaner cost structures, far less debt and recordprofit margins. Consumers are cautious and spendthrift, but not hiding in closets as they were back in 2008. If 2008 felt like Armageddon, 2011 simply feels like a more run-of-the-mill economic slowdown. Make no mistake: it's bleak out there. But a host of positives are also in place, led by corporate profits, the health of the banking system, rising exports (thanks to a weak dollar) and still-low interest rates.

As this market meltdown is of a different stripe than the market plunge of 2008/2009, then so is the game plan. What worked then won't work now, and vice versa. In the fall of 2008, investors with strong stomachs greatly profited from the "bankruptcy" trade. Shares of Ford Motor ( F ) , Hertz Global Holding ( HTZ ) and Domino's Pizza ( DPZ ) all fell below $3. Sure these companies were carrying heavy debt loads, but savvy investors did the math and saw bankruptcy wasn't a likely outcome. As a result, each stock offered once-in-a-generation bargains. Each stock would eventually move back up into the teens -- or higher, and investors walked away with gains of 200%, 300% or even 500%.

There's a simple reason why we won't be revisiting those scary depths: corporate balance sheets are much stronger than before. Ford, for example, now has $8 billion in net cash and, even in a still-weak economy , should see this figure rise to more than $20 billion by the end of 2013, according to analysts in the auto industry.

This isn't to suggest that a wide range of companies are set to imminently deliver major gains. Indeed, it now appears as ifprofit forecasts for many stocks in 2012 will need to come down. Thecurrent stock marketpullback likely accounts for much of that downward revision yet to come.

So whereas the theme of late 2008 was "buy the stocks that people erroneously think are going bankrupt," now the theme is "buy great companies that have loads of cash, steady cash flow and can be had for single-digit forward multiples." Profits may weaken in 2012, pushing those forward multiples from the high-single digits into the low teens, but we're talking about recession-era profits. Long-term investors don't tend to focus on what "trough" earnings look like, they look to see what the company's profits can look like when the economic picture brightens.

Let's use Ford as an example. The auto maker's stock trades for six times projected 2011 and 2012 earnings per share (EPS) of about $2. Let's assume business slumps in 2012 and per-share profits fall to $1.50. Well, shares are trading at about eight times this downbeat view. Now let's think about what Ford can earn when the economy turns up. $3 a share? $4 a share? With a stock trading under $12, that's simply too cheap to ignore.

What I'm looking at now...

In recent weeks, I've been looking at a number of solid blue-chip plays that look increasingly attractive with each passing day. Yes, shares are lower than they were a few weeks ago. But for intrepid investors, this simply makes them more attractive for investors with a long-term view.

As an example, I profiled financially robust blue-chip stocks earlier this week that now sport very low valuations in relation to their earnings and profit margins. [ Read the full article here .]

As a specific example in that analysis, I took a deep look at chip maker Analog Devices ( ADI ) . Back in the spring, I marveled at how the company was in the midst of a very nice upturn in business that was yielding steady margin gains and outsized profits. But recommending a stock that had run from $28 last September to above $40 in the spring is just not my style. I don't "hate 'em when they're loved," but I do "love 'em when they're hated." And right now, shares of this chip maker are in utter freefall, falling below $40 in early July, below $35 in late July, and seemingly headed for $30.

What will Analog Devices have to say on August 16 when quarterly results roll in? I don't know. But I do know the company is using its strong balance sheet for a stock buyback program, and any near-term pressure resulting from a cautious management tone simply means the company will be able to buy back even more stock with its available funds. I also know that thanks to heavy research and development spending, Analog Devices has a very fresh product line yielding market share gains and rising profit margins. Business may not be great in 2012, but I've got a strong sense Analog Devices will be a proven winner in the long term.

This logic extends to other solid companies that I've recently profiled. Companies that generate lots of cash when business is lousy can presumably really fatten the balance sheet when business trends improve. This was my take on RadioShack ( RSH ) , which I profiled this week .

In a similar vein, I recently said the management team at Delta Airlines (DAL) was doing well by sharply cutting expenses in this era of economic uncertainty, holding off on any major investments to focus on continued free cash flow generation. The airline industry is a notoriusly bad place to be when the economy slows, which is why shares are falling sharply. ButDelta 's management team is rewriting this history with a much wiser approach to cash management. Might the airline industry weaken in 2012? Sure, but Delta 's weaker rivals are likely to feel much greater pain, cutting back in places that allow Delta to seize the advantage.

Action to Take --> The plunging market signals the time to step up your research. Ideas can be found among companies with strong insider buying, bulletproof balance sheets, high and sustainabledividend yields, expanding international sales, etc. The list of potential positives simply can't be ignored.

To be sure, you want to stress test any stock to see if the company can handle a reasonable drop in sales in 2012 and 2013 and still emerge with its balance sheet intact and profits in the black. The fact many of them now trade at fresh lows sets up an important entry point. These stocks may fall even further in coming weeks, but since it's hard to time a market bottom, the long-term view should now be dictating your thinking.

-- David Sterman

Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.

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

© Copyright 2001-2010 StreetAuthority, LLC. All Rights Reserved.

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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