Recently, we had a conversation with a client, along the lines of “something must be wrong with XYZ stock, since it keeps going down.”
Certainly, seeing a stock that you own decline is never much fun. But, as in life, it can be dangerous to make assumptions in the stock market. Let’s look at a few common assumptions investors like to make, and take an analytical approach instead.
Don’t assume a stock move is based on fundamentals
Sometimes, events transpire that affect a stock despite having no basis in the fundamentals. For example, an executive might be going through a divorce, so might need to liquidate half of their stock holdings. This doesn’t affect how the company is run, and certainly won’t be press released. Or, maybe a fund manager owns one million shares of a thinly traded stock, and that manager leaves for another job. The new manager comes in, doesn’t like the stock, and decides to sell the million shares. Since it was not his (or her) decision to buy the stock, they are not going to care much at what price they sell it at to clean it out of the just-inherited portfolio. Guess what? That stock is going to be under some pressure. But the company hasn’t changed at all. Sure, sometimes there are ‘leaks’ of company problems, and this can result in some unexplained selling pressure until news is released more widely. It happens. But investors should not just assume a declining stock automatically means a problem stock. On occasion, a declining stock might be a giant buying opportunity.
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Don’t assume a ‘safe’ stock can be ignored
Most investors assume consumer staples stocks, telecoms and utilities are generally ‘safer’ than most stocks in other sectors. This is generally true of course, but we like to remind investors that any stock can decline. And any stock can decline a lot. And quickly. No better example exists recently than PG&E Corp. (PCG on NYSE). For years and years, it was considered a safe blue-chip utility, offering nice steady dividends. But all that changed last year, when it was blamed for the California wildfires. Now, less than six months later, bankruptcy is looming for the company, and shares are down 70 per cent already in 2019. We are quite sure no investor was prepared for an 85 per cent decline in three months in a nice, safe, boring utility. Use this as a warning: Do not get lulled into a false sense of security on any stock. Rumours, real problems, accounting scandals and other issues can take down any company. You best defence? As always, diversification.
Don’t assume a current trend will continue
Now, we like momentum stocks as much as anyone. There is nothing quite like seeing a stock hit new highs, day after day after day. It is a beautiful thing. However, strong price momentum needs to be matched by strong fundamental momentum. Otherwise, you might be setting yourself for buying an expensive stock that is about to experience a slowdown. Expensive momentum stocks that miss growth targets can be very ugly things to own. Watch for rates of company earnings growth, analysts’ upgrades and a company’s history of positive earnings surprises. Once fundamentals shift, it’s usually better to get out quickly rather than ‘hope’ positive trends reappear.
Don’t assume insiders are always right
Lots of investors like to follow whatever insiders do, on the assumption that insiders ‘have an edge’ because of their executive positions at their companies. Sure, sometimes this works. But insider trading is no guarantee of anything. We are getting long in the tooth, so we remember the early 1990s, when most every trust company in Canada ran into trouble with high debt and bad real estate loans. Being newish in the investment business at the time, we watched with interest (not with money invested, thank goodness) as insiders of various trust companies loaded up on their own company’s shares, only to see those shares spiral down to nothing of value. It was a good lesson to learn: Insider buying is positive, but it is certainly not fool-proof. Same with selling. Just because insiders are selling does not mean a stock is destined to go down. Like with other indicators, insider activity needs to be viewed as one factor only. Too many investors quickly react to insider activity without considering the bigger picture.
Don’t assume company executives are telling the truth
Now, we might be on thin ice here, and won’t mention any names, but we have been in countless company meetings where senior executives have straight-up lied to our faces. It was, woefully, a pretty common occurrence when we were fund managers. Now, you may not be having daily meetings with company CEOs like we were, but it will be constructive to take comments from management with a cynical viewpoint. Executives may not be lying outright, but some will stretch the truth, and all will spin things in the most positive light they can. If a CEO forecasts a new product will be on the shelves in six months, maybe assume 12 months for your own analysis. If the earlier timeline is hit, that’s fine. But if not, at least you won’t be surprised!
Peter Hodson, CFA, is Founder and Head of Research of 5i Research Inc., an independent research network providing conflict-free advice to individual investors (http://www.5iresearch.ca).