Many stock prices have fallen heavily over recent months. Indeed, in some cases they have underperformed the S&P 500’s 22% decline since the start of the year.
Many of them are companies that had high growth expectations factored into their market values. They have been disproportionately affected by the impact of rising interest rates that increase the discount rate used to value their future cash flows. As a result, their present day values are lower than they were several months ago. They have also been hit hard by a weakening economic outlook that is expected to cause increasingly difficult operating conditions.
In my opinion, a rapidly evolving economic outlook is an opportune moment for investors to reassess their current holdings. After all, the economy’s prospects have materially deteriorated over recent months and could prompt more difficult trading conditions for companies operating across a wide range of sectors. It is possible that the long-term outlook has changed for some companies, and for others, investors may realize they have made a mistake by buying in the first place.
Companies with weak finances could struggle the most over the coming months. Interest rates are widely expected to further rise in response to the highest rate of inflation for over 40 years. This means that their cost to service debt may increase at the same time as their revenue comes under pressure due to a challenging economic outlook. They may also experience a decline in profitability from rising costs that impact negatively on their margins.
Similarly, companies with weak market positions may struggle in an era where consumer confidence is deteriorating. Indeed, the University of Michigan consumer confidence reading has declined from 85 a year ago to just 50 today. This shows that companies which are unable to differentiate themselves from peers, or have a weak market position, may struggle to generate rising profitability as consumers reduce their spending.
Companies that lack financial strength and have a weak market position may be worth selling given current market conditions, in my opinion. They could struggle to overcome short-term challenges and may be weakened further so that they fail to fully capitalize on a subsequent recovery.
This viewpoint has previously been highlighted by Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) chairman Warren Buffett (Trades, Portfolio). As he once said: “The most important thing to do if you find yourself in a hole is to stop digging.”
Clearly, selling stocks at a loss is always a difficult process. However, in my opinion, it can be made easier by considering the opportunity cost of holding unattractive companies. Selling them and buying stronger stocks with better long-term growth potential may equate to a more logical strategy than holding low-quality companies due to loss aversion bias.
Of course, high-quality companies are worth holding onto throughout all market conditions. They are most likely to survive present economic challenges and prosper in a subsequent period of growth.
Therefore, it is important for investors to reassess their holdings on a case-by-case basis and to come to conclusions based on the individual merits of companies. Doing so could help reduce overall losses and maximize total return potential.
Also check out:
