5 Ways to Test a Stock in a Bear Market

(Daniel Foelber)

An old saying by Warren Buffett goes, “Price is what you pay, value is what you get.”

The volatile price action of the stock market can lead to fears of missing the upside and panic selling on the downside. But in reality, the true value of many companies is much more constant. Even a single quarterly earnings report rarely makes or breaks a company despite potentially big moves in the stock price.

In this bear market, many stocks are down 50% or more from their all-time highs. In some cases, stock prices have clearly become disconnected from real value, leading to a sell-off. But for many other companies, the stock price may be lower for little more than a downturn in the business cycle.

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If your investment portfolio is down and you want to test some stocks, you’ve come to the right place. Here are five methods you can use to ensure a business can survive a prolonged bear market.

Image source: Getty Images.

1. Is the company dependent on debt or diluting its equity to run its business?

Businesses that generate positive earnings and free cash flow can organically fund their operating and capital expenditures. Most industry leading companies fall into this category. Apple (NASDAQ:AAPL) generates positive earnings and free cash flow and does not depend on stock dilution or debt to run its business. In fact, he tends to reduce his number of outstanding shares by buying back shares and therefore increasing earnings per share.

However, many less established and unprofitable businesses may have impeccable growth potential. But this potential depends on bringing products to market and increasing sales, which may not be possible without debt and/or equity financing. Debt financing is less attractive now that interest rates are rising. And falling stock prices and falling valuations make this a bad time to raise money by diluting stocks.

2. Does the company have a competitive advantage?

Big companies like Apple have brand power, pricing power, lots of cash, and clear competitive advantages through product and service integration. However, there are many small businesses that also have competitive advantages.

A good example of a company with a strong competitive advantage is Datadog (NASDAQ:DDOG), a cloud monitoring and analytics platform. The business does not generate consistent positive profits. But that free cash flow has been positive for years. Additionally, it has some of the best customer retention and growth in the industry despite the tough economic climate. It also has more cash on its balance sheet than debt, which gives it a nice security in the event of a slowdown in growth.

Datadog is a great example of a small company that lacks profitability, but is still a great long-term buy for the reasons discussed.

3. Is the business well managed?

When times are tough, companies with great management teams can rein in overspending, make key acquisitions, and emerge on the other side of a downturn a step ahead of their peers. Examining a leadership team’s track record over past cycles is a great way to determine if senior executives are well-equipped to meet challenges.

Chevron (NYSE: CVX) is a good example of the impact a strong management team can have on a business. For years, the company has maintained a rock-solid balance sheet, which has allowed it to maintain dividend growth throughout the COVID-19-induced oil and gas downturn. Chevron also made key acquisitions and was able to buy oil and gas reserves and invest in alternative energy when so many junior oil and gas companies lacked the resources to do so.

Today, the oil and gas industry is one of the few bright spots in the stock market, so it’s no surprise that Chevron is doing well. However, the company’s current position is the result of several key decisions made over the past few years. Chevron’s caution during the latest oil and gas downturn, along with its ability to capitalize on the upside, makes it an excellent dividend-paying stock to hold for the long term.

4. Is the company deploying its capital well?

A measure called return on capital employed (ROCE) takes earnings before interest and tax (EBIT) and divides it by total assets less current liabilities (also known as capital employed). In simple terms, this profitability measure shows how much EBIT a company can generate based on the capital employed. The higher the ROCE, the better.

One of the main reasons why Apple and Microsoft The stocks are both still rising over the past three years and have become the two largest US-based companies by market capitalization due to their ability to use capital efficiently. Despite being big companies, Apple and Microsoft continue to find ways to expand into new markets and use capital efficiently, something many mature companies struggle with. As a result, both companies currently have higher ROI ratios than their five-year medians.

AAPL data on return on capital employed by YCharts.

To further illustrate this point, note how Apple and Microsoft have higher ROCE ratios than smaller, faster growing companies like Advanced micro-systems Where netflix – a testament to their competitive advantages and efficient execution.

5. Does the company have a multi-decade path to growth?

Regardless of a company’s age or industry, the company must follow a path to long-term growth. Without growth, companies cannot increase their dividends, make acquisitions or enter new markets. Revenue and earnings growth justifies rising stock prices. The reverse is true for companies that fail to sustain growth.

Stay balanced and make a calculated decision

A silver lining of bear markets is that investors can see how their favorite companies hold up during a time of heightened volatility and downward selling pressure. Additionally, they can also see how management reacts to challenges and how vulnerable a company is to macroeconomic and secular headwinds.

By stress testing your holdings, an investor can see if a position is worth adding, holding or selling, thus making a decision independent of the price action the market has in store for you.

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Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool holds posts and recommends Advanced Micro Devices, Apple, Datadog, Microsoft and Netflix. The Motley Fool recommends the following options: $120 long calls in March 2023 on Apple and short calls $130 in March 2023 on Apple. The Motley Fool has a disclosure policy.

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