Stock Market Declines: What You Need to Know

What a market downturn can mean to the individual investor

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May 06, 2016
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Market downturns are one of the few guarantees in investing. At some point, stocks you own will experience a decline for one reason or another. It can certainly be an unsettling feeling. It's human nature to let doubt creep into our minds. Did we do enough research? How far will it drop?

Don't worry; today we'll discuss different types of bad news, decipher how it affects stocks and learn what to do when your investments encounter inevitable declines.

?format=2500wTalking points

  • The value investor's philosophy on market downturns.
  • Understanding potential causes.
  • When to buy, when to sell.

Value investing philosophy regarding market downturns

At some point in time, your investments will encounter a swift decline. Maybe with due cause, maybe not. Stocks, and the stock market for that matter, often behave irrationally. According to the efficient market theorists, stocks are always priced equal to their value. However, value investors know this to not be true, and many have the results to prove it.

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” — Benjamin Graham

Benjamin Graham, the father of value investing, knew this. As his quote above states, the market can rise and fall in a matter of minutes for any reason, but in the long run, it evens out and the best businesses end up on top. This is a critical point because it helps value investors see clearly when others are dumping their entire portfolios.

That being said, there are valid reasons for a stock to decline, and investors need to be able to distinguish this. After all, the whole point of investing in stocks is to achieve solid returns, and if you're holding on to a sinking ship, you might be in trouble. So let's take a look at some possible causes for a downturn and what to do if it happens.

Understanding potential causes of stock declines

Declining stock prices can be worrisome, but if you better understand the cause, or potential event, behind the drop, it gives you a better idea of how to act next. Since there can be many precipitating factors, I've decided to lump them in two broad categories: company issues and market issues.

Company issues

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  • Fundamentals – The first factor to consider is the overall health of the company. Is there too much debt? Too little cash flow? Did sales drop drastically? These are all metrics that need to be monitored at least quarterly. The company's health and fundamentals are by far the most important issues to consider. After all, they're part of the reason you invested in the company. If you see sagging fundamentals, too much debt or an overvalued business, it may be time to reconsider your investment.
  • Events  Every now and then an "event" can happen within a company that leads to a significant selloff. Lumber Liquidators (LL, Financial) and Chipotle (CMG, Financial) are recent examples. These "events" can lead to quick declines in stock prices. When confronted with these situations, ask yourself three questions. Do the fundamentals look any worse after the event than before? Does the event prevent the company from increasing sales/earnings? Is management handling the event properly? If the answers are no, no and yes, then you needn't worry. There's also a need to analyze the event in a broader aspect as well. For instance, could it lead to lawsuits, fines or other problems further down the road? These are probably the trickiest types of issues to resolve.
  • Management  What happens when your favorite company, which has given you excellent returns, has a change in management and suffers a price decline? Most of the time, if the company had solid management, it ensures the next group is just as capable. However, if you see a swift exit of several top employees for no apparent reason, there could be bigger problems. Sometimes a key figure can leave and change the entire vision of the company. It's key to follow what the new management says and even more important to watch its actions and determine if they match.
  • Missed earnings  The dreaded earnings miss. Analysts have a tendency to lose their minds when a company falls short by an entire penny (sarcasm), but should you? When in doubt, do the complete opposite of the analysts. Partially kidding. However, you should never buy or sell a stock due to earnings or guidance expectations. Instead refer to your intrinsic value and analyze the company's fundamentals. If you feel everything is in order, you shouldn't worry.

Market issues

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  • Market valuation  Sometimes the entire market, or specific industries, may become overvalued. I have made a spreadsheet specifically designed to help you determine this here. These "bubbles" usually lead to a stark decline in stock prices. You can avoid these crashes by keeping a decent amount of your portfolio in cash when you feel the market is in a bubble and staying away from overvalued stocks. In the event you do experience a crash just remember, you're investing for the long term. Don't dump an investment because an entire industry, or market, is crashing. Instead, look for opportunities that might be created.
  • Competition  A true concern, and one that is often overlooked until it's too late, is simple capitalism. Successful companies, and industries, lead to intense competition. Every now and then a company comes in and completely disrupts entire sectors (think Netflix [NFLX] or Amazon [AMZN]). It's not something to take lightly, especially if it's affecting your investments. If a company comes in and disrupts sales or earnings, it can bankrupt businesses in no time (Blockbuster). In these cases it's extremely important to be vigilant on fundamentals and management. If one starts to teeter, investigate.
  • Regulation  There is a compelling argument for an inverse relationship between the stock market and the Federal Reserve's interest rate regulation. When interest rates are raised, stocks move down. When they are lowered, stocks move up. In other words, when people can get higher interest rates in "safer" vehicles (T-Bills, CDs, etc.), they tend to move their money out of stocks. But the value investor shouldn't be enticed, nor deterred, by the ever-fluctuating interest rates. Remember, in the long run stocks beat every other type of investment.

When to buy and when to sell

Now that you have a better understanding of different causes of stock declines, what do you do? Buy more, hold steady or sell as fast as you can? Let's discuss.

Buy

There is really only one time you ever buy stock in a company – after you've performed diligent research, analyzed fundamentals and management and determined an intrinsic value. But that's not all. You have to calculate a margin of safety that you would be comfortable with before you buy a piece of the business.

Of course you should take into account why the stock is falling. Analyze the scenario and understand it. If you come to the conclusion the market is acting irrationally, as it often does, then review your original assessment and see if anything has changed. If it still looks like a strong, well-managed company, then look into adding to your position.

Sell

Let me be clear; I'm not advocating you go out and load up on any stock that's tanking. If the stock is down or in decline, there is usually a reason. Whether that reason is a rational fear or not has to be determined, which is why it's vital to understand the scenario.

If you determine the reason is a long-term, concrete issue that affects the company's future, then it may be time to sell. But thorough research and valuation still need to be done. After all, that is the definition of value investing. Buy when the company is undervalued and sell when it is no longer attractive.

This is an important distinction and critical to understand when it comes to selling stocks. You don't need to wait for the company to become overvalued to sell a stock. If the business is no longer growing or encounters one of the problems mentioned above that drastically alters its future, then it's time to look for other opportunities. However, the only way to determine this is to analyze the company's underlying fundamentals and calculate an intrinsic value.

Summary

  • Stocks fluctuate in price all the time – sometimes caused by irrational fears and other times by legitimate concerns.
  • Value investors are diligent and do proper research to better understand the causes of these declines.
  • This allows us to be properly knowledgeable about what to do next and act with a level head.
  • The bottom line on buying or selling in these situations harkens back to the basics of value investing – analyze fundamentals, determine an intrinsic value and calculate a margin of safety.