When stock markets drop, especially significantly, it is obviously not very thrilling for an investor unless he invested in a down market.

But a dropping market might not necessarily be such a bad thing after all. Down markets - more often than not - can present perfect buying opportunities.

Turning Bad News Into a Lucrative Opportunity for Your Portfolio

Even the best companies, industries, and sectors fall out of favour from time to time. A well-informed investor, with some cash and a firm understanding of the situation, can calmly get into a turbulent market and buy up shares of these underdogs at a fraction of their value. Or, you can buy put options and profit from a market that's in a downtrend.

But how do you know which companies are permanent losers and which are undervalued gems? Consider the following to determine if you should invest your money or keep it stashed in cash:

Is the problem temporary or long-term?

You must be careful not to simply invest in a company because everyone else is running from it; sometimes there is reason to run! Even after the share prices of companies such as Lucent and United Airlines had been cut by 75%, they still did not constitute a good investment. There are many companies that aren't worth buying at any price. Trash is trash, regardless of how much you pay for it.

In some cases, problems arise that are the result of one-time mistakes on the part of management. During the Savings and Loan crisis, for example, bank stocks were beaten down to almost comical levels. An investor who mentioned he was purchasing shares of these institutions was immediately scorned, mocked, and considered crazy by even close friends.

At the same time, firmly entrenched companies such as Wells Fargo (which boasted a solid balance sheet, established reputation, top-notch management, and steady customer base), were hit just as hard as banks of lesser quality.

At some point though, those that had exercised courage and relied on their analytical judgment by purchasing shares in such banks found their portfolios much fatter. Remember the words of a very wise man; "you are neither right nor wrong because the crowd agrees with you; you are right because your analysis says so."

Is the business an excellent business with a suitable market capitalization?

In your attempt to look for under valuated companies you should focus your interested more on large market leading companies instead of smaller ones.

Companies with high returns on equity, little or no debt, that aren't affected too much by economic trade cycles and that operate in areas where competition is less brutal. Especially in the long-term. Because in the event of a recovery, for example, Wal-Mart is more likely to recover sooner than a small specialty retailer. The owner of smaller companies may find himself waiting considerably longer for his shares to realize their full value in the market.

Does management have an excellent track record?

The best indicator of future performance is past results. Great management tends to produce great results for everyone involved, including the shareholders.

If a company has encountered significant problems for consecutive years while the industry in which it operates prospers, it is likely that management has been unwisely retained. In such cases, you and your pocketbook would be better off ignoring the empty promises of executives who are only interested in keeping their jobs.

The quality of management question is perhaps one of the most important an investor must pose to himself. Coca-Cola is an excellent example of how good management can make a great company even better.

When Roberto Goizueta became CEO the business became a truly global powerhouse, throwing off cash to its stockholders faster than they could gulp it down.

Are you patient enough able to wait out the storm?

After you've determined that the problem a company has is temporary, management has an excellent track record, and the business possesses excellent economics, there is still one question remaining before you should purchase a seemingly undervalued stock.

Are you patient enough to wait out the company's troubles? Do you have the luxury of waiting for the company's value to be reflected in the share price?

Bear in mind what I always preach. “Trading is a business and should be treated like one!” It's not a lottery game.

As investors, we know that a good company will eventually be recognized by the market; we just don't know when.

In the short run, anything can happen. There is nothing to stop an undervalued stock from falling significantly further in price.

You must have the time to wait for the inevitable result of wise investing, regardless of whether it takes a week, month, or several years. In the end, your sound analytical judgment and unshakable patience should be rewarded.

Yours in Successful Trading,
Ricky Schmidt