Buying on Dips: First, Be Selective

In the bull market of the 1990s, no strategy has worked better than buying stocks on dips. Everybody knows that.

But here’s something nobody knows: when a market slide will become so severe that stocks keep going down and early bargain hunters get badly burned.

It’s far too soon, of course, to sound the death knell for a tactic that’s worked like a charm since 1990. Indeed, the current market pullback could very well turn out to be just another great buying opportunity.

Some investors apparently thought so Monday as they pushed some blue-chip stocks up sharply, lifting the Dow Jones industrial average 149.85 points, or 1.8%, to 8,574.85.

“The money we’re putting into [stocks] today is going to look like good investments in six or 12 months,” said Lanny Sachnowitz, manager of the AIM Charter mutual fund.

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Nevertheless, individual investors should be cautious. Blue- chip shares have fallen for four straight weeks, and the Standard & Poor’s 500-stock index still is off about 9% from its July 17 all-time high.

Smaller stocks have been sinking since April. Especially in their case, the buy-on-the-dip mentality has been absent this time around.

Obviously there is no sure way to gauge when a stock has stopped going down--or if this market “correction” will turn into a full-fledged bear market, the first since 1990.

Still, there are some broad rules investors should follow when sifting through the market’s debris for good buys.

* Be very selective: The first rule of bargain hunting is straightforward: Don’t buy a stock just because it’s fallen in price.

After the Dow Jones industrial average plunged 554 points Oct. 27 amid worries over the Asian economic crisis, individual investors led the charge the next day, as the Dow rebounded 337 points.

The market gyrated for a couple of months, but launched into another powerful surge in mid-January.

Anyone lucky enough to catch Microsoft at its Oct. 27 close ($64.38) has gained 67%, with the stock now at $107.31.

But anyone rushing into the Korea Fund that day, when it closed at $8.94 a share, is looking at a 32% loss, as the price has continued to slide to $6 now.

“A common mistake individual investors make is they look at a list of stocks that are down a lot and say, ‘These are cheap. I’m going to go in and buy them and they’ll go back up,’ ” said David Corkins, manager of the Janus Growth & Income fund.

“But very often, stocks are cheap for a reason.”

In the case of any stock or fund tied closely to Asia, the fundamentals had just begun to deteriorate last summer and fall. Few investors realized how bad things would get--and how much cheaper the stocks would get.

A rule that always applies to stock-picking, but that is especially important in a shaky market: Do your homework before buying what you think are bargains.

“Do your best to understand what you’re investing in,” said Jim Margard, a money manager at Rainier Investment Management in Seattle.

Corkins, for example, recently bought entertainment giant Time Warner and computer networker Cisco Systems. Not only did the stocks get cheaper in the market pullback, but Corkins is confident that the companies’ fundamental business prospects are strong.

* Long-term investors should look for companies that lead their industries: If you’re bargain-hunting not for a short-term trade but for an investment that will pay off over several years, it’s best to start with the highest-quality industry leaders you can find--companies likely to survive any industry-related or economy-related shocks that may still lie ahead.

In evaluating those stocks, use traditional valuation measurements as a shopping guide--for example, stocks’ price-to-earnings ratios.

For example, Scott Schermerhorn, manager of the Federated American Leaders stock fund, just bought Boeing, the leading aircraft maker, and Schlumberger, the world’s largest oil-field services company.

Both stocks have been hammered, as Boeing’s earnings have weakened in part because of production problems, and as Schlumberger’s outlook has dimmed with low oil prices.

Schermerhorn’s reasoning in buying the stocks now: By his calculations, they are the cheapest they’ve been in two decades when gauged against the Standard & Poor’s 500-stock index on several valuation measures.

Schlumberger is cheap relative to cash flow and earnings, Schermerhorn said.

Boeing, meanwhile, is trading at a historically low valuation in terms of price-to-book value, or the basic worth of the business.

“Do I know the time frame for when Boeing will come back?” Schermerhorn asked. “Absolutely not. But do I think the worst of the news is out? I can’t think what’s worse for Boeing.”

Rainier’s Margard, also a long-term investor, now likes Avon Products, Quaker Oats, US West and chemical firm B.F. Goodrich.

* If you’re a short-term trader, understand what the market wants: At any point, the market is dominated by certain trends. Right now, the market most favors stocks with earnings reliability and ample liquidity.

That means many investors are afraid to buy stocks that have even a small risk of disappointing Wall Street. It also means they want stocks that trade actively enough so that big investors can quickly enter--and exit.

Both factors would seem to favor large stocks over small ones--the trend since 1994 as well.

“In this market, if [a company] misses a number their stock is absolutely devastated,” said Marty Hurwitz, manager of the IDS Life Aggressive Growth fund. “You need a reasonable prediction of earnings to minimize the number of times that happens.”

Hurwitz is high on radio companies because of good ad sales. He favors Chancellor Media Clear Channel Communications. He also likes Outdoor Systems, SunGard Data Systems, Cambridge Technology Partners, Whittman-Hart, FORE Systems and Xylan Corp.

Jim Gribbell, manager of the Babson Growth Fund, has lately added to companies he believes can notch low- to mid-double-digit annual profit growth.

Among health-care companies, he’s recently added to his holdings of Pfizer; Cardinal Health, a drug-distribution company; and Guidant, a medical products maker. He’s also added to Maxim Integrated Products and Vitesse Semiconductor.

“We’ve been much more active the past week than we have been the past two months,” Gribbell said.

As for liquidity, Margard has only bought stocks lately whose average daily trading volume is $2 million or more. On a $20 stock, that would require that a minimum of 100,000 shares change hands each day.

Liquidity isn’t a direct concern for small investors. They can always sell a few hundred shares. But if bad news hits, it’s likely that institutional investors will sell their shares long before small investors know of the news. So all else being equal, a stock trading a relatively small number of shares will be hurt worse than another stock.

* Be careful about buying the leaders of the last market advance: When a correction hits, investors’ natural inclination is to lunge at the stocks that led the last phase of the bull market.

This is a common mistake, because buying previously leading stocks seems like such a smart thing to do.

Problem is, the leaders of one bull run usually aren’t the leaders of the next. This dynamic is especially pronounced in smaller stocks.

This occurs for any number of reasons. Perhaps investors discovered flaws in a stock that they didn’t see before. Maybe the stock’s industry group or sector has fallen out of favor. Or it simply could be that fickle investors have moved onto the next hot stock.

Whatever the reason, the hot stock grows cold.

Consider MRV Communications, a Chatsworth-based computer networking company.

MRV was a top performer in early 1996, soaring from less than $8.50 at the start of the year to more than $40 five months later. Along with the rest of the stock market, MRV slumped into a correction in the summer.

But as the Russell 2,000 small-stock index began to recover in mid-July and eventually surpassed its old high in January 1997, MRV’s average price was less than $22. MRV flirted briefly with its old high late last year but is stuck today around $18.

Other erstwhile high-fliers with similar patterns include Iomega and Corrections Corp. of America.

* Look for strength: It might seem counterintuitive in a correction, but even when they’re looking to buy dips investors should target strongly performing stocks.

In basic terms, they’re the stocks that fall by a smaller percentage than the market on bad days and rise more than the market on good days.

Such strength is important for two reasons: First, these stocks are likely to hold up better in a protracted downturn.

Second, and more important, this tactic is especially effective at identifying the stocks that may lead the next phase of the bull market. The reason is simple. When the market turns, the stocks investors want most are likely to move up first.

When the market is mired in a correction, many institutional investors hone their wish lists in preparation for better times. When the market finally turns around, the strongest stocks move up earliest as investors quickly pump money into them.

“You want to focus on the stocks that will recover the strongest and that will lead the way,” Corkins said.

To use this strategy properly, you must pay attention to the market so that you recognize when it is turning higher.

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Typically, a key sign that stocks are turning up comes when the market moves up strongly for several days on heavy volume. When that occurs, keep a close eye on the stocks that lead. They might be the best performers going forward.

* Don’t be afraid to sell if a “bargain” goes bad: One of the most common mistakes individual investors make is not selling stocks when they go down. Instead, they hold onto losers, hoping they’ll somehow turn around and make it back to the points at which they bought them.

That’s a dumb strategy in good markets, but it can be disastrous for bottom fishers picking over a dicey market.

When investors buy on dips, they’re hoping that a stock has stopped falling. But they’re implicitly taking the chance that the descent has further to go.

The risk is that a stock is headed for a far deeper loss than an investor realizes and that just one sizable loss can decimate a portfolio. So if a stock falls 8% from the price at which you bought it, many experts say it’s best to sell. Under no circumstances should you tolerate a loss of more than 10%.

In some cases, you’ll end up selling on the low and watching in frustration as the stock moves back up. But you’ve also preserved your capital that can be put toward other stocks.

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Cheap Enough Yet?

How a sampling of big-name stocks’ prices have fallen from their 52-week highs, and the stocks’ price-to-earnings ratios based on estimated 1998 earnings per share.

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52-week Monday Percentage ’98 Stock high close drop P/E Avon Products $89.00 $80.88 --9% 27 Time Warner 100.00 89.63 --10 -- US West 58.00 52.00 --10 18 Pfizer 121.75 104.63 --14 50 Walt Disney 42.75 32.19 --25 33 Hewlett-Packard 82.38 55.25 --33 19 DuPont 84.44 55.06 --35 16 Boeing 58.19 36.94 --37 29 B.F. Goodrich 56.00 35.44 --37 12 Schlumberger 94.44 51.75 --45 18 S&P; 500 1,186.75 1,083.67 --9 23

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Note: P/Es based on analyst estimates tracked by Zacks Investment Research.

Source: Times research