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Bottom fishing for beaten-down stocks

Here are five tips to help avoid value traps in familiar companies with low stock prices.

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Electronics retailer RadioShack (RSH), mobile device producer Blackberry (BBRY), and cupcake maker Crumbs Bake Shop (CRMBQ)—which recently filed for Chapter 11 bankruptcy—are just a few popular companies whose stock prices have been plummeting for quite some time. Whether the writing is or isn’t on the wall for some of—or all—these stocks, investors can find themselves asking, “Should I try to catch a falling knife?”

Unlike the financial crisis—which sent nearly the entire market spiraling toward the abyss—these companies may face fundamental challenges to their businesses, and whether they can recover is yet to be determined.

RadioShack and Best Buy (BBY), for example, are electronics retailers battling to survive in a world increasingly dominated by eCommerce leaders like Amazon (AMZN), China's Alibaba, Japan's Rakuten (RKUNY), and other global online retailers. BlackBerry has been trying fend off trendier phone makers like Apple (AAPL), Samsung, and Nokia (NOK). And in Crumbs’ case, competitors have been able to eat away at the niche market the company had hoped to preserve for itself. Only time will tell if these companies can right the ship, given the decline in their stock value. Of course, each investor must do their own due diligence on every investment opportunity to determine the suitability, in terms of risk versus reward, for their portfolio.

The struggles are evident in their respective share prices. Consider that RadioShack, for instance, is trading under $1 as of July 23, 2014. That’s down from a peak near $80 per share in December 1999 (see the chart below).

As an investor, you might think: “I like cupcakes and electronics, maybe these investments still have value.” For some, it can be tempting to consider buying into stocks of recognizable companies, particularly at extremely depressed prices. After all, value can be hard to find these days, with the S&P 500 trading at all-time highs. But these can be perilous waters to wade into.

As an investor, you must always consider the risk of investing, including the risk of loss. However, if you are looking to go bottom fishing among stocks that are a shadow of their former selves, here are five tips to avoid a value trap.

1. Look at the big picture.

Assessing the time frame of a company’s downtrend can be very informative. Is the stock in decline during a market meltdown, a rally, or a longer-term horizon? Analyzing what the stock is doing relative to the broad market helps provide much-needed context.

Any number of stocks plummeted to reach near-term lows, and in some cases, all-time lows, close to the March 2009 stock market bottom. Investors that went bottom fishing around this time have generally been rewarded handsomely.

On the other hand, recall RadioShack once again. While the Fort Worth, Texas–based electronics retailer has most certainly been affected by the fluctuations of the business cycle, the stock has been in a 15-year slump (see the chart above).

2. Assess the primary drivers of the underperformance.

Consider asking yourself: Are the factors that are pressuring the stock temporary? If not, does management have the ability to right the ship? To make this determination, you should have a clear sense of the drivers of underperformance.

However, it may not always be clear what is causing a stock to sell off. A company may be facing headwinds specific to its business, or there could be deeper issues facing the industry that it operates in. Sean Gavin, portfolio manager of the Fidelity® Value Discovery Fund (FVDFX), does a deep dive into every company he considers for his portfolio. “Check a company’s margins and returns relative to its peers. This can help you determine whether a stock is down because the entire sector or industry is down.”

There are several ways you can assess the core drivers of a business and its performance relative to peers:

3. Look to the fundamentals.

Is there an opportunity to find a strong company at an artificially depressed price, or is the stock a value trap? Assessing the fundamentals of a company—free cash flow, revenue growth and cost structure, and management quality, to name a few—is critical to analyzing any opportunity, including that of a beaten-down stock.

Gavin looks closely at the core operations of a company to see whether it has the attributes of a high-quality business. “High returns on capital or equity over a market cycle is the first indication that the business has a defendable franchise. It is critically important to closely examine the balance sheet of the company you are investing in. If it isn’t solid, then there may be a much higher chance that an investor could suffer a permanent capital loss if the stock’s downturn is lower than expected.”

There’s an abundance of research tools on Fidelity.com that you can use to help evaluate the fundamentals of a company.

4. Consider the technicals.

If you’ve done your analysis and have determined that there is value in a beaten-down stock, the next question may be at what price should you consider buying it? While fundamental analysis can help you determine what to buy and why, technical analysis can help you decide when to buy (or sell). Note that this additional method may be more suitable for active investors and traders who are considering taking a hands-on approach to managing their investments.

There exist key technical price points where a stock might find support and begin to reverse a downtrend. For example, the nadir of the stock market decline, in early March 2009, saw Citigroup (C) fall to just below $1 per share (a widely accepted, psychologically significant technical level). Note that the New York City-based bank did a reverse stock split in 2011, so this value no longer appears on a current Citigroup chart. This price would eventually serve as a bottom support level. The company helped its cause by reporting a profit during the first two months of the year, on March 10, 2009. After the positive fundamental news, there is a strong probability that value buyers came in around the technically significant level of $1 per share to help drive it higher.

5. Manage your risk.

You should exercise extreme caution when trying to catch a falling knife. “The lower the quality of a company that you are looking at when bottom fishing,” Gavin says, “the higher the probability of significant downside. While the rewards can be high if you correctly pick a declining stock that is able to reverse the trend, the odds are very much tilted against you, in my opinion.”

Nevertheless, there are a number of tools you can use to limit the downside when bottom fishing.

Trading orders, for instance, are primary tools that you can use to reduce your exposure to loss. They allow you to set prices at which you want to buy and sell the stock automatically, allowing you to more effectively manage how much risk you are willing to take on a particular position.

A final suggestion from Gavin: “I would highly suggest that you scale into any such position when you find a company that you think will succeed. Remember, it is nearly impossible to perfectly time the bottom of a distressed stock. You will always want to leave room to lower your cost basis if the market continues to move against the stock, even if the fundamentals have started to turn positive.”

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Stock markets, especially non-U.S. markets, are volatile and can decline significantly in response to adverse issuer, political, regulatory, market, or economic developments. Foreign securities are subject to interest rate, currency exchange rate, economic, and political risks, all of which are magnified in emerging markets. Risks are particularly significant for investments that focus on a single country or region.

Past performance is no guarantee of future results.

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