Whenever a broad industry goes into the doldrums - whether due to a decline in business prospects, economic shocks, or simply a business cycle, most investors will try to tiptoe their way around re-investing in the now toxic sector. It can be a very profitable venture for both speculators and value investors, but investing in beleaguered companies should come with an adjusted set of rules. This article will highlight how to successfully see your way back into a troubled sector with your stock investments.

Business Cycles Perfectly Natural

With all of the hundreds of industries operating in our modern economy, it stands to reason that from time to time some will suffer from static, or even falling, revenues. Recent examples include the telecom industry during 2000-2003, the airline industry shortly after the terrorist attacks on the WorldTradeCenter in September of 2001, and in the housing and mortgage-related markets in 2007.

Business cycles have been spotted and defined in recent decades as the natural "boom and bust" cycles of business that occur every three to seven years, on average. Following this pattern, corporate earnings also follow broad trends, with steadily rising profits for some period of time, followed by plateaus or drop-offs. The drops can be very steep, causing many shareholders to lose substantial portions of their investments. (For more insight, see Understanding Cycles - The Key To Market Timing.)

Step 1: Expect the Bad News to Continue
Typically, when an industry turns negative it affects every player to some extent, and stock prices almost always drop in advance of actual earnings. Eventually, the earnings will hit a trough, after which share price performance will gradually improve along with business results.

In the beginning, it helps to assume that the bad news is not done arriving, and that more hits to the stock price may occur. This will work to keep the greed factor down ("I've got to get in now before everything takes off").

Rarely do stocks rebound from a pronounced downturn so quickly that there's not ample time to get reinvested, so don't worry about finding the perfect timing. Look for deep discounts in valuation, book value and other fundamental metrics. Just because a stock is down 25-30% from its high doesn't mean it's a screaming buy. It could still fall even more, so don't overextend yourself on a large initial position.

This investing approach is essentially a combination of value investing (based on valuation and other metrics) and aggressive investing. The aggressive part is in going after a falling knife that has currently negative sentiment and may not have a clear road to recovery. The value investing portion is in finding companies that may be trading at deep discounts to historical market norms for metrics like price/book, price/revenue and price/earnings. (To learn more about value investing, see Stock-Picking Strategies: Value Investing.)

Step 2: Look Deep in the Statements
It's time to roll up your sleeves and dig into those dry Securities and Exchange Commission (SEC) filings - it's usually the most comprehensive source of information investors will get. (For more insight, see Introduction To Fundamental Analysis and Advanced Financial Statement Analysis.)

Find out exactly what is on the balance sheet. First of all, company debt should be vigorously examined. This means going as far as knowing the covenants - you'll want to know exactly what portion of the debt is due, and when. Compare this with the company's operating cash flow for a quick feasibility check on its ability to repay debts.

Next, consider the company's credit rating and access to the credit markets. Will it need a cash infusion during the next 12-18 months? If so, will the company find cheaper or more expensive debt than what it currently has? This can have a major effect on a company's capital allocation decisions. In addition, if a company accesses a source of capital that the market feels is too expensive, investors may respond by selling or reducing their stock positions.

Are litigation issues keeping the stock (or industry as a whole) down? Look for management's comments on the situation, along with any specific outstanding court cases, which companies must disclose in quarterly and annual reports (10-Qs and 10-Ks, respectively).

Step 3: Examine the Price Trends in Shares
Looking at stock price histories and charts over the period during which negative events have occurred can give you a better feel for how bad news has been affecting the stock price.

Pay special attention to days when earnings warnings or other negative news were released to the public, looking for the magnitude of drops on those days as well as the analyst community's reaction; the latter can often be found in news wires, media releases and upgrade/downgrade reports issued within a few days of the negative event.

There is certainly no definitive chart or graph for determining exactly how much a stock will fall based on the onset of a specific negative event or trend, such as a broad-based drop in revenue across an industry. Look for positive trends such as less selling off after recent bad news as opposed to the earlier bad reports; this could be a sign that the markets have priced most of the bad news into the current stock price.

Step 4: Be Willing to Wait It Out
Investing in toxic industries often means holding a position well beyond the point at which the bad news stops. You will likely have to wait until good news starts to flow in again, and this could take a couple of years to occur. Many technology companies didn't see accelerating revenue and earnings growth until early 2004, or even later following the Nasdaq collapse of 2000-2002. However, many tech stocks had cumulative returns over the period between 2000 and 2005 that handily outpaced the broad market. The point here is that even if you miss the bottom by 10-20%, being willing to wait out the downturn could bring higher returns in the long run.

Be prepared for upside surprises to come slowly; it takes time for company management to get a feel for the business environment after an industry-wide disaster and it may not accurately predict future quarterly earnings based on emotional or other non-business factors. Channel checks and industry reports often don't return any solid information until long after the worst of it is over because the prevailing psychology ("business is bad") tends to linger for a while.

Step 5: Start with a Smaller Position
Ask anyone who has tried to do it a number of times and you'll quickly find out that it's very difficult to pick a bottom perfectly. A lot of very smart investors believed they had found the bottom in stocks like Kmart, Worldcom and Tyco long before those stock prices scraped the floor. Stocks can be very volatile to the downside when news is bad, even more so if the stock has a beta larger than the market-based average of 1. (For more on this measure, read Beta: Know The Risk.)

Consider only buying a position (such as one-half or even one-third) of the amount you would normally invest with. Set up a schedule to fill out the position based on specific guideposts such as quarterly earnings reports, where the company meets predetermined guideposts for revenue growth, margins or cash flow growth. This will keep your attention focused on the current news feeds, and starting smaller will help prevent exposure to huge losses if it turns out you jumped the gun a little early.

Every industry will go through hard times, but these downturns can create solid investment opportunities for those who can balance the patience and aggressiveness required.

A stock that rebounds well may quickly become a favorite in your portfolio, but try not to be biased because of a short-term gain you've achieved. Having goals in place for total return and other company metrics like revenue, profits and margins will help to frame the investment and allow you to tune out short-term market noise.

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