Shares in a downtrend: when to hold on and when to run for the door

In life we all know that certain things are inevitable – death, taxes, and declining share prices for a cherished investment.  There is nothing you can do about shares in a downtrend.  But you can and you should control how you react to the fall.

Some investing strategies advise selling when the share price reaches a pre-determined loss – such as 8% or 10% or 15%.  Ask no questions, they counsel us, just sell.

Opponents of these sell strategies caution against adopting the herd mentality prevalent in most markets – shoot first, and ask questions later.  Instead, they counsel us to investigate and see if we can determine the cause of the decline.  What’s more, we are told if the results of our research yield no fundamental changes in current or expected future performance, not only should we not sell, we should buy more shares.

Along the way, newcomers to share market investing read repeatedly that they should not become emotionally involved in the shares in which they invest.  On the other hand, investors with longer-term horizons are told to think of share purchases as ownership investments in a business.

Human nature often puts roadblocks in our path and emotional attachment to shares of a given company is often one.  If you were actually buying a business to operate instead of to invest, wouldn’t your emotions come into play?

If you have spent countless hours on your computer, poring over annual reports and reading research reports on a share in which you have interest, how can you not feel a sense of attachment once you buy?

The truth is, not everyone can avoid emotional attachments.  Many retail investors take a great deal of pride in the investments they have made after exhaustive reading and research.  It is not easy to bid a fond farewell to such a share and move one.  Yet in some instances, move on we must.  Hanging on to shares too long is one of the greatest pitfalls of retail investing.  How can you tell when you should sell?

In the vast majority of downtrends, investors will find the driving force responsible for the fall in one of the following three areas:

1.    Issues within the Market
2.    Issues within the Industry
3.    Issues within the Company

Market Issues

Bear markets alone may frighten the herd into panic selling, but intelligent investors remind themselves markets go up and down.  We are only now recovering from one of the greatest financial crises in history.  At the onset of this GFC, investors by the thousands fled the share market and moved their money into fixed income securities and gold.  Suppose you were the proud owner of some BHP shares and you sold them at a loss in 2008.  Let’s look at a 5-year chart for BHP and see what has happened to the share price.

Note that in less than 3 years, BHP’s share price has regained all the value it lost during the height of the GFC.  Not all shares on the ASX are yet to recover all they lost.

When you look at BHP’s price versus the ASX200, you can see how well it has performed against the benchmark index since late-2008:

However, history of share market investing tells us that over time, companies that are still fundamentally sound will recover. Investors who were “buying while everyone else was crying” at the depths of the GFC have realised returns approaching 70%.

Not all downtrends can be as easily attributed to something as historically significant as the GFC.  Comparing the price movements of your shares against the market as a whole or the industry sector in which your shares operate provides a check for more typical market issue driven downturns.

If the rising price of oil, or the flooding in Queensland, or the nuclear disaster in Japan is a possible driving force, use the charting feature on thebull.com.au to see if your shares are following the overall pattern of the market or the sector.

As a retail investor, you always have to be aware of the real possibility that large institutional investors may know something you don’t know.  If the sector has declined 5 to 10% but your shares have dropped 20%, it might be time to say good-bye.

Industry Issues

All shares are grouped into industry classification schemes, depending on the nature of the industry in which they operate.  Many industries are cyclical in nature, with revenue generation varying in seasonal or other patterns.  Some industries move in concert with the overall economy, such as certain retail sector shares.  When consumers are spending less, expect a downtrend in some of your retail shares.

Again, using charting to compare the price movements of your shares with the sector can be helpful.  If your shares stgiate substantially from the pattern, something inside the company may be going on.  Since shares of some companies within the same sector rely on different market segments, the best practice here is to compare the price movement of your shares against a direct competitor.

Once again, if the drop in the price of your share differs significantly from that of its sector or closest competitor, it is definitely time for further investigation and it may be time to say goodbye.

Regulatory changes in an industry frequently serve as a driving force for price movements.  If the regulations add significant costs to the operations of the business, all companies within the sector can expect reduced profitability and companies with substantial debt may not survive.

Industry sectors can change dramatically due to technological advancements and new competition.  The American automobile industry went into a long period of decline when Japanese automakers entered that market.  Growth in desktop personal computers is slowing with the introduction of smart phones and tablet computers.

Company Issues

In most cases the kind of fundamental change significant enough to justify getting completely out of an investment comes from within the company itself.  Many retail investors return from work to find one of their shares has suffered a dramatic price decline.

In most cases, such immediate declines are due to some extraordinary event, such as a natural disaster, a product recall, or a lawsuit.  This common occurrence is a classic result of the shoot first, ask questions later mentality.  The question investors should be asking is whether the fundamentals of the company have changed because of the extraordinary event, or do they remain the same.

If the event has not altered the company’s ability to generate earnings going forward nor changed the way the company must do business, there is no real fundamental reason to sell.

All other company specific issues than can send share price into a tailspin need to be viewed with that same question in mind.  Earnings announcements that miss estimates can drive down share price.  Reduced guidance going forward can drive down share price.  Management changes of key personnel can drive down share price.  Competitive products or services entering the market can drive down share price.

None of these matter if they do not affect the company’s ability to continue with its business model and generate earnings for its owners.  The better you know the company behind your shares and the details of its business model, the easier it will be for you to address those issues.  If you know the company’s products and markets, you will know when it is time to say good-bye and look for another opportunity.

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