Prepare for the Crash

The stock market crash following the Internet bubble destroyed portfolios -- and dreams. The Nasdaq alone fell from 5,000 to below 1,200 -- nearly an 80% decline. And that's only the average. Many stocks became essentially worthless. The tragedy wasn't in the numbers, though -- it was in the effect those losses had on people. Many investors were completely wiped out, losing money they'd been saving for years.

At Motley Fool Inside Value, we specialize in identifying stocks that not only outperform on the upside but can also survive a crash relatively unscathed.

Diversify now
Investors with technology-focused portfolios suffered the most a few years ago. There was almost nowhere in the sector to hide, with even the strongest companies suffering huge declines. Analog Devices (NYSE: ADI) fell 80%, Agilent Technologies dropped 90%, and CheckFree (Nasdaq: CKFR) plummeted almost 95%. Even now, these companies aren't close to their pre-bubble highs. And again, these are some of the strongest companies in the sector.

The moral of the story isn't that technology companies are risky, but rather that diversification is a key component of a crash-resistant portfolio. While tech has been dreadful, the Vanguard REIT Index would have nearly quadrupled your money since 2000, and energy stocks have had outstanding returns as well. A diversified portfolio that included technology, real estate investment trusts, and oil would have prospered. Diversification also ensures that you get the full benefit of your stock-selection skills. The crash demonstrated that it's no condolence to identify the best-performing stocks in the worst-performing sector. Being the best of the losers doesn't make you a winner. But if you pick the best of each sector, you'll do quite well.

The Inside Value newsletter follows this diversification philosophy by recommending stocks in sectors ranging from technology to finance with market caps from $1 billion to $300 billion. Even our selection strategies vary: We'll search for everything from undervalued growth stocks to cheap businesses poised for a rebound after suffering downturns or temporary bad news.

Buy cash
The problem with the companies that fell the most when the bubble burst was that they had neat ideas but didn't actually make any money. Even some of the most popular companies had this problem, including Priceline.com (Nasdaq: PCLN). Before the crash, Priceline was drowning in red ink, having never posted a profit. But investors assumed that it would be a great investment because it had a rapidly growing top line and an innovative pricing strategy. That was a costly mistake.

Unprofitable companies have little flexibility in bad business climates, and they tend to do poorly in bear markets. In a panic, investors aren't buying dreams. They're sticking with consistent cash machines, steady blue-chip companies such as Hershey (NYSE: HSY) and Nike (NYSE: NKE). It's no coincidence that these two companies show spectacular long-term returns, unfazed by the last bear market. Businesses that earn gobs of cash don't have to raise money to survive. They can even take advantage of poor conditions to gain market share from weaker competitors. Such businesses tend to be crash-resistant.

At Inside Value, every single pick is a business that makes piles of cash and has a significant competitive advantage. Consequently, these companies position themselves well for a bear market or (worst-case scenario) a market crash.

Be skeptical
One of the best ways to guard your portfolio against a market crash is by maintaining a healthy level of skepticism. Wall Street isn't a charity; it's a bunch of businesses focused on making money for themselves. Helping small investors make a profit is item No. 382 on the list of Wall Street priorities, falling immediately below ensuring that the new assistant knows exactly the right amount of milk and sugar to put in everyone's morning coffee.

Be skeptical of analyst forecasts, whether they're predicting that oil will hit $110 a barrel or that ADC Telecommunications (Nasdaq: ADCT) will break $175 a share. While ADC's price targets were trumpeted on TV before the crash, I haven't seen many apologies for the stock's subsequent performance. It's now trading at around 10% of the price target set back then.

Rather than blindly trusting the analysts, make sure you understand the companies you're buying. Understand what risks each business faces, and what competitive advantages will help the company overcome hurdles. Be particularly wary of high growth estimates, because analysts tend to be optimistic, and high growth is difficult to sustain. If the company fails to achieve overly ambitious growth estimates, the stock will be hammered. Finally, buy a stock only if, after conservative analysis, the company is trading at a bargain price. Stocks tend to return to their intrinsic value, so buying below that value provides significant protection in a crash.

We follow these techniques at Inside Value by performing our own research, starting with a thorough understanding of the company. As part of each recommendation, we not only describe what the company does, we also discuss the competitive landscape and possible risks. Finally, we recommend only stocks that are trading at dirt cheap prices.

Foolish final word
While a crash will hurt any portfolio, a few carefully chosen strategies can help you avoid the worst and give you the opportunity for big gains along the way. If you're interested in reading our recommendations, we offer a free, no-risk 30-day trial, which gives you access to all issues, a discounted cash flow calculator, dedicated discussion boards, and five special Inside Value reports.

Whatever you do, start planning your blueprint for a bear-resistant portfolio.