Even bad times are good for something

By Jim Jubak

The best way for most of us to make money in the stock market over the long term is to own shares of good companies.

Separating the good from the bad and the ugly, however, isn't easy in the best of times.

But, just in case you haven't noticed, these aren't the best of times.

So here's my advice to you. Use the worst of times -- well, at least the worst since the 1982 recession -- to find the companies that will come out of this crisis in as good or better shape than they went in, and to identify those companies that were either never as great as we thought they were or that have been fundamentally damaged.

Perhaps the only upside to a vicious recession like this one -- combined with a global financial crisis -- is that it ruthlessly magnifies every corporate flaw. It separates the great companies from the once-great, the fatally flawed from the fundamentally sound, the smoke-and-mirrors acts from the conservatively managed, and the companies built for the good times from those built to survive all kinds of weather.

This, rather than by obsessively watching the day's stock prices or mourning your losses, is how you get ready to make money on the other side of this bear market.

Put your watch list to good use

How do you put this advice into action?

Use your watch list for a practice run. Start by pruning your watch list to learn how to use the clues that this crisis and recession have provided. Ruthlessly go through your watch list to practice separating future good companies from those that aren't so good anymore or that looked good only when times were flush. Keep an especially sharp eye out for those few companies that are going to come out of this recession and crisis stronger than they went in.

Pruning your watch list is essential preparation for profiting from the eventual upturn in the economy and markets. It will turn a list of 40 vague "maybe I'll buy it" stocks into a focused list of 10 high-conviction buys.

And it's not nearly as emotionally draining as going through your actual portfolio and realizing that some of the stocks you've stuck with, taking big loss after big loss, don't deserve your loyalty.

Now, about that portfolio . . .

Once you've had the practice of pruning your watch list, you're ready to do the same to your portfolio. Identify the keepers and tag those that don't make your quality cut for sale. Not today, mind you. Stocks are now powerfully oversold, and we're due for a sharp but probably short rally in this ongoing bear market. This rally could be explosive. Remember that the rally off the Nov. 20 lows took the Standard & Poor's 500 Stock Index ($INX) up more than 20% in just about six weeks. Dump the stocks that don't make your cut then. And add the proceeds, no matter how small, to the cash you've got on the sidelines waiting for the turn in this market.

Let me show you how you can use this crisis to separate the good from the bad companies by using the watch list I've been putting together for Jubak's Picks since the summer of 2008.

I'll start that process by talking about what I'm not going to pay much attention to: stock prices. In fact, at this point in this bear market, I'd say ignore current share prices -- except in the aggregate as an indicator of trends and an eventual turn in the market as a whole. They're simply not a good indicator of a company's quality moving forward.

Take special care to avoid the "rearview-mirror" trap that many investors fall into during an extended market downturn. During the 2000-02 bear market, I was deluged with e-mails that said, "When do you think Stock X will get back to $80 a share (or whatever)." The not-so-hidden assumption in that question was that since the stock traded at $80 in the past, it would trade at $80 at some point in the future. Not true then and not true now. Take all past share prices with a kilogram or three of salt.

GE used to be at $40 . . . so?

General Electric (GE, news, msgs) doesn't have to rebound to $40 a share after this bear market is over just because it traded at $40 a share before the bear market started. So much has changed for General Electric that the $40 share price in 2007 is irrelevant.

Former CEO Jack Welch restructured an industrial and consumer company to put financial services at its core. GE Capital in its heyday was responsible for about 50% of the company's revenue. The business model at GE Capital was built on the foundation of an AAA credit rating that gave the division access to huge amounts of cheap money through the commercial paper market. In the current crisis, the commercial paper market has almost dried up, endangering GE Capital's source of capital. And the losses at GE Capital, plus the risks in its huge portfolio, have put that AAA credit rating at risk.

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It's safe to say that in the future GE Capital won't be able to raise as much money or as cheaply, or to leverage its capital to the same degree, as in the past. And that will cut into the profitability of this half of General Electric's business. If GE isn't as profitable as it used to be, why should the stock trade at $40 a share again anytime soon?

You do want to pay attention to stock prices so that you don't overpay for good companies. (Just ask Warren Buffett, who loaded up on ConocoPhilllips (COP, news, msgs) near the top of the oil market, how painful that can be.) But since you're probably not buying much of anything right now -- as you wait for some sign that the bottom is near -- there's no reason to obsessively follow stock prices.

Continued: Good company at work

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