Despite October’s blockbuster stock market performance, there were some high-profile situations when stock prices fell in a breathtaking manner. That’s why it’s important to have a game plan in place, so that when one of your stocks falls 20% or more in one day, you have already rehearsed the situation in your mind and you’re better prepared to make a relatively quick and wise decision.
There are many reasons that a stock can fall suddenly. Some of these stocks bounce back within a few weeks or months, but others keep falling and then stagnate for so long that you lose hope of ever recouping your principal.
Here are the questions to ask yourself:
• Did the stock fall because of a speculative rumor?
• Did the stock fall because of an unfortunate one-time event?
• Did the stock fall because of a continuing problem that will affect this year’s—and maybe next year’s—profitability?
• Did the stock fall because of a scandal that will cause distrust of the company’s products and/or leadership?
Back in December 2011, shares of Mead Johnson Nutrition (MJN) fell 15% in one day, due to a speculative rumor. One baby died in an American hospital, and a second baby became ill. Mead Johnson is the maker of Enfamil, the infant formula that was used by that hospital. News stories immediately questioned whether the infant formula was to blame.
I thought about the situation. It seemed to me that if a batch of Enfamil were contaminated with bacteria, then there would be dozens of babies affected in a multi-state area. Instead, there were two affected babies in one hospital. After reading the company’s statements about its product safety measures, I determined that this would be a brief downturn for the stock and that news media were jumping to rash conclusions. Sure enough, the FDA assured the public that there was no bacteria found in the Enfamil product. The stock began rebounding within a week, and completely recovered within two months.
Unfortunate, isolated incidents are more common. Get ready to cringe: planes crash, chemical factories catch fire and norovirus outbreaks occur on cruise ships. These are personal disasters for all the people involved. But from a corporate point-of-view, the companies can continue flying and ferrying passengers around the world, producing chemicals and otherwise conducting business. From a financial point-of-view, the companies might take a charge against that quarter’s earnings for the expenses associated with the disaster, but those costs don’t typically affect future earnings.
Therefore, if you own a stock in a company that experiences a big one-time problem, the general future of the company remains the same as it did before the incident took place. A profitable, growing company will continue to be a profitable growing company, and its stock price will recover in the coming months.
However, you should be concerned and ready to take action when news emerges that damages a company’s multi-year financial prospects or reputation. Whether it’s several years of misstated earnings (Hertz Global Holdings), suspicion of revenue fraud (Valeant Pharmaceuticals) or cheating on emissions tests (Volkswagen AG), shareholders will likely see their stock fall, continue to fall and then stagnate. It could be years before the stock price recovers.
As an investor, you want to cut to the chase quickly. If possible, ignore the news media, because their goal is to get you to pay attention to their news. They do that by focusing on and sensationalizing one or two facts or innuendos, which could easily have nothing to do with the truth.
I go right to the analyst reports. Wall Street analysts have relationships with public companies. They’re intimately familiar with the companies’ finances and able to quickly determine the potential impact of an unfortunate event to a company’s bottom line.
If your stock price falls due to a one-time event, which does not apparently also involve a scandal, you will likely see the stock recover in the near future. But if your stock price falls because of an ugly financial situation or a corporate scandal, sell! In this scenario, you will lose money. That’s why we’re confronting this potential scenario today, while we’re calm.
Here’s the multiple choice question: If your stock’s value falls from $10,000 to $5,000, which would be the best way to make that $5,000 grow again?
A) Leave the money invested in a company with a deteriorating earnings outlook or riddled with scandal.
B) Sell the stock, and reinvest the capital into an undervalued growth stock with a bullish chart.
C) Sell the stock, put the capital in a money market fund, then obsessively watch the stock price every day for the next two years.
I sure hope that B is the obvious answer.
Stock investing is a learned skill. It can be complicated and frustrating. It can also be lucrative, exciting, interesting and fun. Nobody’s going to be great at stock investing, right out of the gate. It takes practice and discipline. Anyone can watch a stock go up 50% and pat himself on the back. But the amount of wisdom you exhibit on the darker days will determine your long-term success.
