MarkHulbert

CHAPEL HILL, N.C. (MarketWatch) — Is it possible to find stocks that perform well in both up and down markets?

You will need to think big and cheap.

An additional advantage such stocks would possess: Unlike other bear-market strategies, this one would provide downside protection without having to go to cash. That means investors don’t have to forfeit the upside if the market keeps rising.

Buffett to release shareholder letter

Paul Vigna and Erik Holm discuss Warren Buffetts annual letter to Berkshire Hathaway shareholders, and Andria Cheng looks at the aftermath of Richard Schulzes failed bid for Best Buy. Photo: Getty Images.

To find such stocks, I searched the more than 600 stock-picking strategies tracked by the Hulbert Financial Digest for those that did well during both the 2000-02 and 2007-09 bear markets. To make sure I hadn’t come up with approaches that are permanently bearish, I eliminated those that weren’t also above-average performers during the intervening bull-market periods.

Good news: There were a number of services — a dozen, in fact — that satisfied my search criteria. Among them: Investment Quality Trends, edited by Kelley Wright; Blue Chip Investor, edited by Steven Check; Investor Advisory Service, edited by Douglas Gerlach; and Morningstar Stock Investor, published by Morningstar in Chicago.

Almost without exception, the winning strategies favored stocks with large market capitalizations and so-called value stocks — those with low price-to-book ratios. The clear lesson: Large-cap value is the best category for performance through thick and thin.

Might the large-cap value’s sector’s good fortune during the last two bear markets have been a mere fluke? To eliminate that possibility, I analyzed all bear markets since the mid-1920s, using a database maintained by Eugene Fama and Kenneth French, finance professors at the University of Chicago and Dartmouth College, respectively.

Recent experience turned out to be in line with the historical data: During the last century’s bear markets, the average value stock did markedly better than the typical growth stock — sporting a high price-to-book ratio, in other words. This tendency was particularly pronounced among the value stocks with the largest market caps.

There is a catch. Even though large-cap value is the preferred category for providing a measure of downside protection during bear markets, it is important to be choosy even among those stocks that otherwise fall into this group. Researchers have found that even some of them are likely to lose a large amount during liquidity crunches — such as the credit crisis of 2008-2009, the aftermath of Long Term Capital Management’s bankruptcy in 1998 or the 1987 crash.

Lubos Pastor, a finance professor at the University of Chicago who co-wrote one of the first academic studies of stocks’ sensitivity to liquidity crunches, says companies in the financial sector are especially vulnerable during such periods. This is important to note, he adds, since the sector otherwise dominates the large-cap value category. Because the financial sector currently is the largest of any in the Standard & Poor’s 500 large-cap value index, investing in an index fund pegged to that benchmark would therefore be an inferior way of reducing your portfolio’s vulnerability to a credit crunch.

Pastor says investors wanting to protect themselves also should avoid companies that are particularly dependent on external financing. Their stocks almost certainly will fall a lot more during such crises than those of companies that have large cash reserves or are able to meet their cash needs internally.

Be warned that while the average large-cap value stock also goes up during bull markets, the sector often is beaten by small-cap growth stocks — especially when the market is surging higher. The classic example is the go-go years of the late 1990s, when Internet stocks thrived and large-cap value produced relatively small gains.

But boredom and modest profits might seem a small price to pay for the downside protection that large-cap value stocks often provide. During the 2000-02 bear market, in fact, the dozen all-weather strategies on the Hulbert Financial Digest’s monitored list produced an average gain of nearly 2%, even while the stock market as a whole was losing more than 40%.

And while they weren’t as fortunate during the 2007-09 downturn, they nevertheless beat the market — losing seven percentage points less, on average, than the market as a whole.

So which stocks would be favored today by an investor wanting to increase his equity portfolio’s ability to withstand a downturn? To find out, I compiled a list of stocks recommended by the dozen advisers who performed the best during the last two bear markets and who have also done well in the intervening bull-market periods.

Four stocks were recommended by at least four of these dozen advisers. 3M MMM, +1.69% the industrial conglomerate, trades at 16.5 times its earnings over the past year, compared with 17.9 for the S&P 500 index. International Business Machines IBM, +0.75% the information technology firm, has a price/earnings ratio of 14.0, while medical-technology company Medtronic MDT, +0.93%  has a multiple of 13.8, and retailer Wal-Mart Stores WMT, +1.50%  trades at 14.2.