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Stock Watch

4 Stock-Picking Techniques for a Nasty Market

Seeking bargains is just the start for a shrewd investor looking for gains.

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1. Make volatility your friend. The summer swoon unsettled stock investors, but it was a great opportunity for those who were prepared, says Hugh Johnson, a money manager in Albany, N.Y. Johnson used the downturn to snap up shares of such high-quality companies as Apple (symbol AAPL, $110) and Target (TGT, $77).

See Also: 7 Good Stocks That Keep Raising Dividends

Stock market volatility is likely to persist for months, which means you’ll probably get more opportunities to buy at discounted prices. How do you prepare for such occasions? The best strategy is to assemble a list of stocks you’d like to buy but can’t because they’re too expensive. Take Apple. At a price of $110, the stock is 19% below its record high of $135. You may conclude that Apple is still too pricey but you’d be happy to own it at $100 per share. Add it to your shopping list, and don’t be surprised if it hits your buy price; the stock traded as low as $92 on August 24, the day the market experienced a mini crash. (All other prices are as of September 3, 2015.)

Volatility can work both ways, so be ready to act if the market zooms back up. Standard & Poor’s 500-stock index surged 6.4% over August 26 and August 27. Use stretches like that to lighten up on your holdings, suggests Jeff Knight, head of global asset allocation at Columbia Threadneedle Investments. “Conventional wisdom tells you to buy and hold,” he says. “But there’s nothing wrong with selling when the ongoing investment potential is no longer compelling.”

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2. Focus on value. In the race between the tortoise and the hare, the hare has been way out in front lately. Over the past year, the S&P 500 Growth index, which tracks the faster-growing companies in the S&P 500, beat the S&P 500 Value index, which tracks the index’s slower-growing but cheaper firms, by 7.6 percentage points. That kind of performance divergence doesn’t last forever, so it’s a good time to focus on the tortoises: companies, and sometimes entire industries, selling at bargain prices.

One entire industry that’s in the doghouse, for obvious reasons, is energy. But as the price of oil has slumped, investors have punished some good companies unfairly, says Matt Berler, president of Osterweis Capital Management. He cites three master limited partnerships: Enterprise Products Partners (EPD, $27), Magellan Midstream Partners (MMP, $70) and Plains GP Holdings (PAGP, $19). All transport oil and gas to refiners and storage facilities, and all operate on long-term contracts that pay based on the volume of the products passing through them, not the price of oil or gas. All three yield 4.2% or more. (MLPs can cause tax headaches, so consult with your tax adviser before you invest.)

If you can assume more risk, consider energy producers and services stocks. Some companies with the potential for big rebounds are Carrizo Oil & Gas (CRZO, $36) and Diamondback Energy (FANG, $67) among small producers and Helmerich & Payne (HP, $55) and Weatherford International (WFT, $10) in services. For more on this battered group, see 8 Beaten-Down Energy Stocks to Pick Up on the Cheap.

Bargains aren’t limited to the energy sector. Although its name may make you think of a hare, Swift Transportation (SWFT, $19), one of the nation’s biggest trucking companies, clearly belongs with the tortoises. The stock sells for just 10 times projected year-ahead earnings because of concerns about the strength of the economic recovery. But analysts expect Swift’s profits to rise by 23% in 2015 and by 14% in 2016. If the company comes through, the stock will prove to be a steal. For other bargain-priced stocks, see Good Stocks Trading at Bear-Market Prices.

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3. Beware sky-high valuations. Highly valued stocks engender controversy. Columnist James Glassman writes this month that stocks with even triple-digit price-earnings ratios can be attractive “if a company has a fabulous new idea for a business”. He cites Amazon.com (AMZN, $504), Facebook (FB, $88) and Netflix (NFLX, $101) as prime examples.

In hostile markets, though, high-fliers can quickly lose altitude. Netflix, for example, tumbled 23% between August 6 and August 24. And keep in mind that Amazon plunged 77% when tech stocks plummeted during the 2000–02 bear market.

Consider what happened to another nova, LinkedIn (LNKD, $179), after it reported disappointing results in late April. The stock, which was then selling for 84 times estimated 2015 earnings, sunk 19% in one day and today is 30% below where it stood before the earnings news.

LinkedIn and the others may still turn out to be winners. But if a firm stumbles or a bear market arrives, your portfolio could be decimated. Make sure you can handle steep drops, both financially and emotionally.

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4. Look for revenue growth.Over the long term, stock prices track corporate profits. But companies can goose earnings per share by cutting costs and buying back stock. If you want to make sure you’re investing in a company capable of generating sustainable growth, focus on the top line: revenues.

Unfortunately, companies with rapidly expanding sales often trade at stupendous valuations. To find fast growers selling at fair prices, we asked FactSet, a research firm, to filter for members of the S&P 500 with market values of at least $10 billion that are expected to generate sales growth of at least 5% both this year and in 2016 and whose stocks trade for less than 20 times estimated year-ahead earnings.

The screen uncovered 61 firms. Many were in the health care sector, including CVS Health (CVS, $102), Allergan (AGN, $297), and biotech leaders Amgen (AMGN, $149) and Gilead (GILD, $102), the last one trading at a shockingly low 9 times estimated earnings.

One name on the list outside of health was consulting hotshot Cognizant Technology Solutions (CTSH, $63). It sells for just 20 times estimated year-ahead earnings, even though analysts expect revenues to increase by 21% this year and 14% next year. Likewise, Skyworks Solutions (SWKS, $85), a maker of smartphone chips, sells for just 14 times projected year-ahead earnings, yet analysts see sales jumping by 14% in the fiscal year that ends in September 2016. (To learn more about Skyworks and its role in the “Internet of Things,” see 13 Stocks to Cash In on World-Changing Trends.)

See Also: How to Be a Better Investor in Today's Market