How to Find Beaten-Down Stocks That Bounce Back

How Do You Find Beaten-Down Stocks That Bounce Back?

Whenever an industry goes into the doldrums—whether due to a decline in business prospects, economic shocks, or simply a business cycle—most investors try to tiptoe their way around reinvesting in the struggling sector. While it can be a very profitable venture for both speculators and value investors, investing in beleaguered companies should come with an adjusted set of rules.

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

Key Takeaways

  • While it can be profitable for speculators and for value investors, investing in beleaguered companies should come with an adjusted set of rules.
  • Downturns can create solid investment opportunities for those who can balance the patience and the aggression required.
  • Some useful rules for finding down stocks that may bounce back include expecting bad news to continue, digging deep in the financial statements, analyzing stock price trends, be willing to wait, and starting with a smaller position.

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 steep, causing many shareholders to lose substantial portions of their investments. 

Understanding How to Find Beaten-Down Stocks That Bounce Back

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.

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

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 more hits to the stock price may occur. This will work to keep the greed factor down—the "I've got to get in now before everything takes off" mindset.

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% to 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 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.

2. Dig Deep in the Statements

It's time to roll up your sleeves and dig into those dry Securities and Exchange Commission (SEC) filings. Usually, these are the most comprehensive source of information investors will get.

Find out precisely what is on the balance sheet. Company debt should be vigorously examined. This means going as far as knowing the covenants—you'll want to know precisely 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 in the next 12 months to 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).

3. Analyze the Trends in Stock Price

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.

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 is that even if you miss the bottom by 10% to 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.

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 the news is bad, even more so if the stock has a beta larger than the market-based average of 1. 

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.

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