Shares are up from the March lows, but the recovery is stalling. Still, there are plenty of cheap, high quality companies you can confidently buy today.
If you missed the March 2009 market bottom, you might be kicking yourself. I know I am. The FTSE 100 is, after all, up over 20% from its March 9 low.
But just as it was unwise to panic-sell when everyone around us was losing their heads, it's equally unwise to panic-buy now that the market has rallied.
The sudden switch in investor sentiment -- from stocking up on gold, potatoes, and baked beans in early March to "everything's going to be mostly OK" just four months later -- is reason enough to be sceptical of this rally.
The key to investing success, as always, is being patient and continuing to buy quality companies trading at good values. This rally, however, has largely been led by inferior companies that had been heavily shorted and left on death's doorstep.
Trying to hitch a ride on them now may be tempting, but proceed with caution.
Rubbish Stocks
Following a string of notable failures, from retailers like Woolworths to once-mighty financial institutions like HBOS, investors rightly began to wonder who would be the next to fall.
Indeed, the futures of a number of well-known but heavily indebted British institutions were in serious doubt. Taylor Wimpey (LSE: TW) and Enterprise Inns (LSE: ETI), for example, were at one point trading at 17p and 32p, respectively. Both companies have naturally been under tremendous pressure to shore up capital and responded by raising additional capital in the case of Taylor Wimpey, and both companies have scrapped their dividends.
Since March 9, Taylor Wimpey shares have gained 106% and Enterprise Inns 197%. These are just two examples of the recent "dash to trash" in this market rally.
Put simply, this rally's been largely led by weak hands. While it may be tempting to jump on this bandwagon now, these are the worst stocks to buy today, especially since we're not completely out of the economic woods just yet. If things take a turn for the worse again, chasing these stocks could be a very costly mistake.
Instead, investors (as opposed to speculators) should focus on profitable companies that generate free cash flow, that have a track record of rewarding shareholders with efficient use of capital, and that have strong balance sheets.
These are the types of companies that will emerge from macroeconomic turmoil even stronger than before.
Names, Please
Despite the recent rally, there are still many quality companies trading at reasonable valuations that are worth further research, including the following.
Given their size, you shouldn't expect any of these companies to become a ten-bagger in a matter of weeks the way Pendragon (LSE: PDG) did recently, but you can sleep a little better at night knowing your management team isn't slashing dividends or raising money just to pay the bills.
Foolish Bottom Line
After sustaining significant losses over the past year, it may be tempting to chase after struggling companies that have had huge run-ups in this rally, but do your best to not lead yourself into that temptation. If buying distressed stocks was a gamble in early March, it's an even bigger gamble now that many have soared in price. Another downturn in the market and they could be going from heroes back to zeroes -- literally.
The market's still a volatile place, so remember to stay patient and focused on buying the companies that actually turn a profit, have strong balance sheets, and are led by top-notch management. Begin by building a watchlist of stocks you'd love to own if they fall another 10% to 20%. This way, you're ready to strike when the market gives you the opportunity.
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> A version of this article was originally published on Fool.com. It has been updated by Bruce Jackson, who has an interest in ICAP and GlaxoSmithKline.
