


At Motley Fool Inside Value, we specialize in identifying stocks that not only outperform on the upside but can also survive a crash relatively unscathed.

Diversify now
Investors with technology-focused portfolios suffered the most a few years ago. There was almost nowhere in the sector to hide, with even the strongest companies suffering huge declines. BMC Software (NYSE:BMC) fell 85%, while Citrix Systems (NASDAQ:CTXS) and Yahoo! (NASDAQ:YHOO) each dropped 95%. Even now, these companies aren't close to their pre-bubble highs. And again, these are some of the strongest companies in the sector.

The moral of the story isn't that technology companies are risky but rather that diversification is a key component of a crash-resistant portfolio. While tech has been dreadful, the Vanguard REIT Index would have nearly tripled your money since 2000, and energy stocks have had outstanding returns as well. A diversified portfolio that included technology, real estate investment trusts, and oil would have prospered. Diversification also ensures that you get the full benefit of your stock-selection skills. The crash demonstrated that it's no condolence to identify the best-performing stocks in the worst-performing sector. Being the best of the losers doesn't make you a winner. But if you pick the best of each sector, you'll do quite well.

Buy cash
The problem with the companies that fell the most when the bubble burst was that they had neat ideas but didn't actually make any money. Even some of the most popular companies had this problem, such as Vignette. Before the crash, Vignette was drowning in red ink, having never had a profitable year. But investors assumed that it would be a great investment because of its products targeting the hot Web applications niche. That was a costly mistake.

Unprofitable companies have little flexibility in bad business climates and tend to do poorly in bear markets. In a panic, investors aren't buying dreams. They're sticking with consistent cash machines, such as steady blue chips Legg Mason (NYSE:LM), 3M (NYSE:MMM), and PepsiCo (NYSE:PEP). It's no coincidence that these three companies show spectacular long-term returns and were unfazed when the bubble burst. Businesses that earn gobs of cash don't have to raise money to survive. They can even take advantage of poor conditions to gain market share from weaker competitors. These businesses tend to be crash-resistant.

Be skeptical

Be skeptical of analyst forecasts, whether it's a prediction that oil will hit $110 a barrel or that Broadcom will break $300. While Broadcom's price targets were trumpeted on TV before the crash, I haven't seen many apologies for the stock's subsequent performance. It's now trading at about 13% of the price target set back then.

Rather than blindly trusting the analysts, make sure you understand the companies you're buying. Understand what risks each business faces and what competitive advantages will help the company overcome hurdles. Be particularly wary of high growth estimates, because analysts tend to be optimistic, and high growth is difficult to sustain. If the company fails to achieve overly ambitious growth estimates, the stock will be hammered. Finally, buy a stock only if, after conservative analysis, the company is trading at a bargain price. Stocks tend to return to their intrinsic values, so buying below that value provides significant protection in a crash.


Foolish final word



Fool contributor Richard Gibbons is scared of stock market crashes, large flying objects, and eerie music. He does not own shares of any of the companies mentioned in this article. Yahoo! is a Motley Fool Stock Advisor recommendation. 3M and Legg Mason are Inside Value picks. The Motley Fool has a disclosure policy.
