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How to Avoid Bubbles and Busts in the Stock Market
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How to Avoid Bubbles and Busts in the Stock Market

Avoid the worst stocks in a market bubble by following these stock-picking criteria

As bad as the stock market crash of 2008 was, investors eventually got their money back and then some. Worse than a market bubble is the countless investments in individual companies that go completely bust.

How can an investor avoid these catastrophic losses? Are there warning signs before the crash and how can Main Street investors avoid the market hype?

The Intelligent InvestorThis article is the 17th in our chapter-by-chapter review of The Intelligent Investor. The book was first published in the early 50s by Benjamin Graham, widely-known as the father of value investing and a mentor to Warren Buffett.

I’m reading through the 2003 edition which includes the 1973 text from Graham and the updated commentary by Jason Zweig. The book is an amazingly concise yet thorough education in investing for both defensive investors and those that want to reach for higher returns.

Click to start at the beginning with our Introduction to The Intelligent Investor

Check out last week’s chapter 16 review of convertible bonds

Chapter 17 is titled ‘Four Extremely Instructive Case Studies’ and summarizes four examples of spectacular stock busts. The examples highlight four different cases of how management or investors sent share prices to ridiculous heights only to see prices tumble afterwards.

As instructive as the cases were, the market has repeated each several times over and Zweig points out four more cases in the notes.

The good news is that you can avoid being caught the next time investors push a stock price up without reason.

Why Do Investors forget about Fundamentals in Stock Picking?

Graham summarizes four cases where a company’s stock surged only to become essentially worthless only a few years later. Each case demonstrates a common cause we see frequently in the market including:

  • A large, established company using accounting trickery to hide its weakening position and support the stock price
  • A company fueling its business almost entirely on acquisitions that cannot be sustained
  • An uneven merger of two companies
  • An IPO priced on unrealistic expectations of future growth

The financial accounting in the examples gets a little heavy for most investors but the concepts are easy enough to understand. Zweig points out four more companies that highlight the problems in more recent times.

Maybe more instructive than the case studies themselves is the timing for each. All four of Graham’s cases occur in the last few years leading up through 1968, during which the S&P 500 jumped 30%, and Zweig’s cases all occur over the last years of the internet bubble.

The lesson here is that rising markets enable these kinds of crazy investments. It’s euphoric investor sentiment for stocks that helps fuel the idea that even the weakest companies will continue to do well.

When economic weakness hits the general market, these questionable investments always crumble as investors come to their senses.

How to Avoid being Caught in the Next Stock Bubble

How do you avoid the herd mentality behind high-flying stocks as the market heads higher? It’s not always easy to watch a stock surge two- and three-times its recent price and not want to jump on the bandwagon.

The best think you can do is have a written process for picking stocks. This means writing down the criteria you’ll use before you buy a stock including the highest you’ll go in each criteria.

stock-picking-criteria-investingWe covered some potential criteria in the chapter 14 review with some of Graham’s simple stock-picking rules.

  • Strong financial condition with current assets at least twice that of current liabilities.
  • Positive earnings for a decade and growth for at least five years though I would relax this requirement to include some newer companies that haven’t been around for a decade.
  • A 20-year history of dividend payments though you could probably relax this to five years to include some newer stocks.
  • Cheap stocks with a price-to-earnings of 15 or less or a price-to-book value of 1.5 times or less

Without a written guide for your stock criteria, you’ll be too tempted to move the goal posts every couple of years with the rest of the market. The price of the S&P 500 increases to 20-times earnings so you rationalize that you can increase your stock criteria to 18-times earnings…only to buy expensive stocks just before a market crash.

Using strict criteria for investing could leave you waiting months or longer to find stocks in which to invest. That’s fine.

Don’t be afraid to walk away from the table. If nothing looks good at the buffet, then don’t eat for the sake of eating.

Grab your copy of The Intelligent Investor and follow along with our chapter-by-chapter review.

Pick stocks with a strict set of criteria while diversifying your portfolio with broader index funds and you won’t have to worry about a stock market crash. Stock picking and buying individual stocks gets a bad name because investors chase after investments even beyond their better judgement. Use the advice you find in the book and on this blog to pick good stocks of great companies.

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