5 Ways to Stress-Test a Stock in a Bear Market

An old Warren Buffett saying goes, “Price is what you pay, value is what you get.”

The volatile price action of the stock market can lead to fear of missing out on the upside and panic selling on the downside. But in reality, the true value of many companies is much more constant. Even a single quarterly earnings report rarely makes or breaks a company despite potentially sizable moves in the stock price.

In this bear market, there are many stocks that are down 50% or more from their all-time highs. In some cases, stock prices clearly got disconnected from true value, leading to a steep sell-off. But for many other companies, the stock price may be lower for little more than a downturn in the business cycle.

If your investment portfolio is down big and you want to stress-test a few stocks, you’ve come to the right place. Here are five methods you can use to make sure a company can outlast a prolonged bear market.

Image source: Getty Images.

1. Is the company reliant on debt or diluting its stock to run its business?

Companies that generate positive earnings and free cash flow can organically fund their operational and capital expenses. Most familiar industry-leading companies fall into this category. Apple (NASDAQ: AAPL) generates positive earnings and free cash flow and isn’t reliant on diluting its share count or taking on debt to run its business. In fact, it tends to reduce its outstanding share count by buying back stock and therefore increasing earnings per share.

However, many less established and unprofitable companies may have impeccable growth potential. But that potential is dependent on bringing products to market and growing sales, which may not be possible without debt and/or equity financing. Debt financing is less attractive now that interest rates are rising. And declining stock prices and lower valuations make it a bad time to raise cash by diluting stock.

2. Does the company have a competitive advantage?

Large companies like Apple have brand power, pricing power, plenty of cash, and clear competitive advantages through product and service integration. However, there are many small companies that also have competitive advantages.

A good example of a company with a strong competitive advantage is Datadog (NASDAQ: DDOG), a cloud monitoring and analytics platform. The company doesn’t generate consistent positive earnings. But it has been free cash flow positive for years. What’s more, it has industry-leading customer retention and growth despite the difficult business climate. It also has more cash on its balance sheet than debt, giving it a nice failsafe in case growth slows.

Datadog is an excellent example of a smaller company that lacks earnings power but is still a great long-term buy for the reasons discussed.

3. Is the company well run?

When times are tough, companies with excellent management teams can limit excess spending, make key acquisitions, and emerge on the other side of a downturn with a leg up on their peers. Looking at the track record of a management team through past cycles is an excellent way to determine if the top brass is well equipped for challenges.

Chevron (NYSE: CVX) is a good example of the impact a strong management team can have on a business. For years, the company has kept a rock-solid balance sheet, which gave it the ability to sustain dividend growth throughout the COVID-19-induced oil and gas downturn. Chevron also made key acquisitions and was able to buy oil and gas reserves and invest in alternative energy when so many smaller oil and gas companies didn’t have the resources to do so.

Today, the oil and gas industry is one of the few bright spots in the stock market, so it’s not surprising that Chevron is doing well. However, the company’s present position results from several key decisions made in past years. Chevron’s prudence during the last oil and gas downturn, as well as its ability to capitalize on upside, makes it an excellent dividend stock to own over the long term.

4. Does the company deploy capital well?

A metric called return on capital employed (ROCE) takes earnings before interest and taxes (EBIT) and divides it by total assets minus current liabilities (also known as capital employed). In simple terms, this profitability metric shows how much EBIT a company can generate based on capital employed. The higher the ROCE, the better.

One of the big reasons Apple and Microsoft stocks are both still up big over the last three years and have grown to become the two largest U.S.-based companies by market cap is because of their ability to use capital effectively. Despite being large companies, Apple and Microsoft continue to find ways to expand into new markets and use capital effectively, something that many mature companies struggle with. As a result, both companies currently have higher ROCE ratios than their five-year medians.

AAPL Return on Capital Employed data by YCharts.

To further illustrate the point, notice how Apple and Microsoft have higher ROCE ratios than smaller and faster-growing companies like Advanced Micro Devices or Netflix — a testament to their competitive advantages and effective execution.

5. Does the company have a path toward multi-decade growth?

No matter how old a company is or the industry it is in — the company must have a path toward long-term growth. Without growth, companies can’t boost dividends, make acquisitions, or achieve product penetration into new markets. Growing revenue and earnings justify rising stock prices. The opposite is true for companies that fail to sustain growth.

Keep even-keeled and make a calculated decision

A silver lining of bear markets is that investors get to see how their favorite companies hold up during a period of heightened volatility and downward selling pressure. What’s more, they also get to see how management responds to challenges and how vulnerable a business is to macroeconomic and secular headwinds.

By stress-testing your holdings, an investor can see if a position is worth adding to, holding, or selling, thereby making a decision independent of the price action the market throws at you.

10 stocks we like better than Datadog

When our award-winning analyst team has a stock tip, it can pay to listen. After all, the newsletter they have run for over a decade, Motley Fool Stock Advisor, has tripled the market.*

They just revealed what they believe are the ten best stocks for investors to buy right now… and Datadog wasn’t one of them! That’s right — they think these 10 stocks are even better buys.

See the 10 stocks

*Stock Advisor returns as of August 17, 2022

Daniel Foelber has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Advanced Micro Devices, Apple, Datadog, Microsoft, and Netflix. The Motley Fool recommends the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool has a disclosure policy.