Sunday, 1 December 2013

An Introduction to Bottom Fishing

Whenever there is a sustained down period in the market, one of the first things you are likely to hear investors talk about is bottom fishing. In bear markets or in general, when the market has gone down for a period of time, certain stocks will be taken down to a lower level than they deserve to go.

A lot of investors enjoy the challenge of bottom fishing. A lot of them also wrongly assume bottom fishing and picking market bottoms are the same thing. The main reason they are not the same thing has to do with the fact that you are not trying to call the end of a market down turn.

Bottom fishing is, in essence, buying stocks that are on sale. On the other hand, picking market tops or bottoms deals with prediction, and that is a complicated and impossible feat to achieve successfully on a regular basis.

An investor can employ many strategies when it comes to bottom fishing. The following paragraphs describe some of the most popular that many investors and professionals use to identify the right stocks. Keep in mind that there is not going to be any one solution to picking the right bottomed-out stock. A blend of strategies can make the selection process easier.

Technical Analysis and Bottom Fishing
Technical analysis is the use of charts, as well as stock price, to help determine the correct stock to buy. Technical tools make it easier to spot an oversold stock. This oversold stock may indeed be the perfect candidate.

Using technical analysis means that you don't have to worry about the fundamentals of the company. Your concern is price action.

Technicians have many tools and different charts they can use to help identify a stock ready to make a rebound. But, although technical analysis is a very powerful tool, it is also time consuming to learn.

Learning to identify chart patterns can be a difficult endeavor. You must also become fluent in the use of indicators that help you gauge market activity. Learning all of this takes time and patience.

Fundamental Analysis and Bottom Fishing
If being a technician is not your thing, maybe you would prefer looking at the stock a little more deeply than just its price alone.

Fundamental analysis, also known as value investing, is the philosophy of studying a company's balance sheet, as well as understanding its business, to pick a stock that is undervalued. The biggest advantage to fundamental analysis comes in the form of identifying stocks that have been ignored by other traders. Remember: You are searching for value.

In this case, value comes in the form of price per share -- the current price per share versus what you think the price per share should be. Because you are a fundamentalist, this price per share has you buying stocks that are on discount with the hope that the market will move the stock to your target price.

Learning to read a company's balance sheet is a difficult and slow process. And, finding an undervalued stock is still no guarantee that the stock price will move to meet what the perceived price should be.

The 52-Week Low and Bottom Fishing
You have all heard about the 52-week low. Well, one of the ways to find potentially bottomed-out stocks is by searching for stocks that have dropped over a certain period or dropped by a certain percentage. You could easily do a search for a stock that has fallen 70 percent or more in value within the last 18 months or so. You could look for stocks that have made new one-year lows, for example.

Buying the Beaten Big Caps
This strategy is simple. You are buying the biggest market-cap stocks that have taken a down turn -- the best of the big-name stocks. Every market has them. The ideology holds that these bigger-capped stocks will still have viable businesses that are just out of favor. Or, they may have missed a couple of quarters in their earning revenues.

Sometimes, there can be an internal management issue that has little or nothing to do with the business. Any one of these factors can lower a stock's price quickly. No matter the market or how big the company, at one time or another, that stock can be on sale. Once the sale has occurred, the bottom fisher needs to decide if the downward move is justified or an overreaction to something else.

Another benefit to buying these beaten-down big-cap stocks is their yield. Many times, these companies pay a dividend. If the dividend has not been cut, you are now able to buy a higher-yielding stock for a lower price. These are rare, and when they are a worthy investment opportunity, you need to act quickly.

A Word of Caution about Bottomed-Out Stocks
Technical and fundamental analysis, as well as looking for 52-week lows and buying beaten big caps, can all be excellent ways to look for potentially bottomed-out stocks. These discounted prices mean you can purchase a bigger stake. So, any upward move in the price is quickly rewarded. Usually, this will mean that you are buying companies in sectors that are essential or that you believe will make a comeback in the near future.

Keep in mind that there is often a reason why certain companies have lost 70 percent or more of their value in a short time. Those same factors do not change overnight. You need to invest cautiously.

You should keep in mind that a lower stock price can be an indication of future trouble. So, be cautious and decide to purchase only after you have done your research. You should also realize that there is no guarantee that a company will be able to rebound this time. If there are underlying problems, this could only be the beginning, and the price may head lower in the future.

The most important factor in successful bottom fishing is market timing. I said at the beginning of this article that market timing was impossible to do consistently, and that is what makes bottom fishing so difficult. You do not know if the price you are paying is at the lowest it can go or if it will go lower.

Investors looking to bottom fish need to be prepared for the potential of buying the stock of a company that may not exist in the near future. So, although the up side is high and, with time and patience, you will be rewarded for the good picks, you want to limit your bad picks because those can be quite costly.

There is no exact way to know which of the stocks you bought will be winners in the future. Keep in mind that bottom fishing can be rewarding as long as you are prepared for the potential pitfalls.

By John Devcic*