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Investing During Stock Market Crashes: Undervalued Stocks

By Edited Nov 13, 2013 0 0

A stock market crash may be one of the scariest and stress producing situations for many, especially stock speculators and traders. During a crash the only thing you see is the value of your holdings going down and your accounts net liquidating value disappearing. For many people this can be so frightening that they end up selling their positions and losing money. While the initial crash lasts a day the after effects can last for many days and months especially if everyday there are more disappointing news about the economy.

For a value investor looking at the stock market and stock quotes after a market crash is like entering a store and finding everything on sale. To quote Warren Buffet: “Be fearful when others are greedy and greedy when others are fearful”. During a crash lots of people are in a panic that sends stock prices down as more people put more and more sell orders out. To add to the mayhem, many traders use stop loss orders that trigger sell orders at a certain share price to protect them from losses. If the market goes crazy and share prices plummet, these sell orders may trigger and cause prices to go down even more. Some people speculate that some of the worst dips in the market during the financial crisis were the result of stop loss orders triggering to falling stock prices one after the other.

A value investor specializes in finding companies that are selling at a good price or are undervalued and there is no better moment to go bargain hunting than the day after a market crash. To a value investor the price paid for a security is extremely important because it will influence the return on that investment so the lower the price the better the end result. Paying $50 for a stock that climbs to $75 returns 25% while paying $65 for the same stock returns 13.3% there is no way around it, the cheaper the stock relative to earnings the higher the return. In the case of dividend stocks, yields also go up as the price of a stock slides.

 A stock trading at $100 that sends $3 a year yields 3% if the same stock loses 25% of its value during a panic that lasts a few months and drops to $75 it will yield 4% to investors that buy it during the downturn. Imagine the difference in total returns over the years especially if we take into consideration that buying a cheaper price means more shares for the same amount of money invested. Again, what is important is paying a good price for a business that can be held for years. It is not uncommon to watch dividend paying blue chip stocks climb back to their pre crash levels in just a few days as value investors and dividend and income investors start buying up shares of companies that have durable competitive advantages especially those in the consumer staples sector like Coca Cola, Pepsi, Procter and Gamble and many others that are basically recession proof stocks. Investors who had the courage of buying companies like these during the market meltdown have been richer ever since. Some share prices have more than doubled compared to what they were trading at during the recession and we are not counting the effects that reinvesting dividends may have had. Some of Wells Fargo’s preferred shares that yielded around 8% at par value where even trading at discounts to par of 40% which would yield more than 12% in fixed income and offered a possible capital appreciation of at least 30%!

Value investors are not the only ones that can profit from crashes in the stock market. Traders can also make some cash during times where volatility reins. As mostly every stock goes down in price shares move to undervalued territory. Some blue chip stocks are known to be caught up in a price range that doesn’t seem to change for years and during times like these it can be easy to do small range rebound trades to make some money every week. Of course, if your are thinking about doing some range rebound trading stick with companies that are solid and that have no problem delivering profits to shareholders in case the stock goes down after you placed the trade and you are forced to hold the stock for a few months while you wait for the rebound. If the stock pays dividends you may enroll your account into an automatic DRIP in case the shares stay down for more time than expected. This way reinvested dividend payments would help you reach the breakeven point faster than what the stock alone would. Of course, this doesn’t apply to day traders how trade in and out of stocks daily and live from the profits generated by their daily trades.

The most important thing to take advantage of market crashes is to have cash to invest. A dip in the price of shares will be no good if you don’t have a penny to invest. For this reason it is very important to have some cash in your brokerage account. Some investment advisors recommend to have at least 10% of your portfolio in cash which is very good idea considering the how unpredictable the market behaves. Cash is king when shares prices fall so having a decent amount of cash in your portfolio comes in handy when everything is on sale. If your are struggling to add cash in your portfolio you may consider  not enrolling some dividend stocks that look overvalued or preferred shares that are trading above par value in dividend reinvestment programs so that the income received from those securities piles up in your account. This way you will have some cash handy when the right moment comes to go on a share shopping spree. Never neglect the importance of cash in your portfolio. There is nothing more frustrating that watching shares of your favorite companies selling for cheap and not having the cash to buy them. Trust me on this one. I have been in this situation a few times recently and believe me you will want to bang your head against a wall for missing out on great investment opportunities.

Note: This article is for educational purposes only. It is not a recommendation to buy or sell any security. Use your own judgment when you invest or seek help from a financial advisor.

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