Recognize the risks
While dumpster diving for stocks can be a profitable enterprise, investors should be ultra-cautious when investing in troubled companies. All of the dumpster stocks I highlighted above caused investors significant pain in the months and years prior to their recent rallies. There are a few ways to make sure you win more often than you lose.
1) Margin of Safety: Always build in a big margin of safety when buying stock of a company with significant competitive challenges. Simply put, that means that you should try to calculate a very conservative estimate of what the company is worth, and only buy the stock if it drops (for example) 20%-30% below that conservative valuation. It’s better to miss some opportunities than to overpay for a company with uncertain prospects.
2) Start small: Don’t bet your whole fortune on a dumpster stock you’ve just discovered, even if you think it is substantially undervalued. Start small, and if the price continues to drop, consider that as an opportunity to buy more.
3) Be patient: It can take years for a stock to come in line with its “intrinsic value.” While it’s nice when dumpster stocks quickly spring back to life — like the four I highlighted above — this investing strategy requires taking a long-term view of what a company is worth. (I was very surprised at how quickly HP and Best Buy rebounded from their lows)
4) Stay detached: Keep up to date on the company’s fundamentals (particularly earnings performance), and make sure that nothing significant has changed from your initial evaluation of the stock. If the company’s problems are much more severe than you anticipated, you need to be ready to cut your losses.
5) Consider options strategies: Options are volatile investment vehicles compared to stocks, and are not suitable for beginning investors. However, if you understand how options work, they can be useful for investing in companies where it’s hard to calculate the intrinsic value. For example, look at Research In Motion Ltd (NASDAQ:BBRY)’s earnings for the past three years:
Research In Motion EPS, past three years: data by YCharts
Through 2010 and early 2011, Research In Motion Ltd (NASDAQ:BBRY) appeared to have steadily rising earnings. Then, the QNX operating system (which eventually became BB10) was hit with multiple delays, Research In Motion Ltd (NASDAQ:BBRY)’s market share sank, and by mid-2012, the company was losing money. Call options allow you to minimize your downside in the event that things go south. That’s a big advantage, since it’s impossible to be right 100% of the time.
Foolish conclusion
Dumpster diving for stocks should never be the “bread and butter” of your investing approach. By nature, it is somewhat more speculative than investing in higher-performing businesses, although the focus is still on long-term value. If you can find a great company at a good (or great) price, that should be your first investing target! I think Apple Inc. (NASDAQ:AAPL) might be such a company today.
Nevertheless, sometimes it’s hard to find many great companies at acceptable prices. In that case, investors with a long time horizon can profit from the market’s occasional irrationality by investing in beaten-down stocks when Wall Street becomes overly pessimistic. Disagree? Let me know in the comment box below!
The article Warren Buffett Doesn’t Buy Junk Stocks (but Maybe You Should) originally appeared on Fool.com and is written by Adam Levine-Weinberg.
Fool contributor Adam Levine-Weinberg owns shares of Apple, Hewlett-Packard Company, and BlackBerry, and is long Jan 2014 $13 Calls on BlackBerry. Adam Levine-Weinberg is short shares of Amazon.com. The Motley Fool recommends Amazon.com, Apple, and Berkshire Hathaway. The Motley Fool owns shares of Amazon.com, Apple, and Berkshire Hathaway.
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