STREET SENSE:The fundamentals of stock market investing
Even Good Stocks Get Cheap
You want to buy stocks when they're bargains, but you have to know whether they

The best investor I've ever met has one simple rule that guides all of his stock purchases.

"I buy good stocks when they're cheap," is his brief answer to almost any question about his investing philosophy.

But how does he define what's "good?" And how does he determine when a stock is "cheap?"

His strategy: He's always looking to buy the stocks of solid companies whose shares have dropped sharply because of temporary business disappointments.

PICKING THE UNPOPULAR STOCKS

For example, several years ago, he bought a number of energy-related stocks when the price of oil slipped to near $10 a barrel and energy stocks went into a freefall.

Why did he make such a major commitment to the energy sector?

"Because OPEC still has the power to get together and control oil production and pricing," he said at the time. "Energy is a scarce commodity that will always be needed. You should always buy the good oil stocks when they're cheap."

He also bought shares of IBM when the stock dropped 20% after the company announced a major earnings shortfall. He invested in the major drug companies when the Clinton administration launched its attack on the pharmaceutical industry in 1993. He even purchased Philip Morris stock when those shares dropped on fears of a huge tobacco litigation settlement. All of these investments resulted in substantial profits.

"When a stock or group of stocks drop sharply, it's either due to a temporary situation that's fixable or a fatal problem that can't be solved," the investor told me. "My only real decision is to weigh the potential risk against the possible reward and then either buy or leave the situation alone. All good companies have problems from time to time. If you buy their stocks when other investors are focusing only on the problems, your risk is very small."

FIXABLE OR FATAL?

But how can he tell the difference between a temporary setback and a potentially catastrophic problem?

"The first thing I look at is the company's financial health," he said. "Companies that get into deep trouble usually have taken on a lot of debt. When business turns bad, the debt becomes a crushing burden that they can't overcome. On the other hand, companies with little or no debt are in a much better position to bounce back from adversity."

The investor says he also tries to evaluate the reputation and track record of a company's management.

CHEAP ISN'T ALWAYS A BARGAIN

"Remember when 'Chainsaw' Al Dunlap got all the credit for increasing the share price of Scott Paper and then selling the company?" he asked. "Dunlap moved on to become the CEO of Sunbeam, the appliance maker, but he had no success there and Sunbeam's stock dropped sharply. I took a look at Sunbeam at that low price, but decided to pass on it. There was just too much history of shaky management for me to have any confidence in the company's ability to come back."

One good way to hone your skills at evaluating potential "comeback" stocks is to study the list of major companies whose shares are making new yearly lows on the New York Stock Exchange. If you can build a solid case that a company's problems are temporary, you're probably looking at a low-risk bargain. 

Ophthalmology Management Associate Editor Jerry Helzner has written more than 50 articles on stock investing for Barron's. He has been a regular stock market columnist for other business publications and was a member of the equity research department of a major regional brokerage firm.