Legends are made and careers are destroyed by large price movements in a stock over a short span of time.
Let us look at two examples.
One of the early successes of Warren Buffett was his investment in American Express in the mid-1960s. American Express was hit by a scandal, referred to as the Salad Oil Scandal, which caused its stock price to fall from $65 to $37. Buffett invested a massive 40% of his partnership assets in American Express and the rest, as they say, is history.
Bill Miller, a fund manager with an outstanding track record from 1991 to 2005, saw ‘opportunities’ in beaten-down stocks like AIG, Wachovia, Bear Stearns and Freddie Mac in 2008. He bought these stock when they fell significantly from the highs. And when they kept falling, he kept buying more of them. His 15-year track record got wiped out in a single year.
In India, we keep seeing such gyrations in various stocks and sectors, where individual stocks or sectors fall 50% and more from the highs. There could be various reasons for the fall.
Real estate or infrastructure stocks such as DLF, Unitech, GMR or GVK fall out of favour.
Stocks like Ranbaxy or Dr. Reddy’s correct on account of notices from the US Food and Drug Administration (USFDA).
Stocks like Financial Technologies or MCX correct due to problems at National Spot Exchange Limited (NSEL).
Nestle falls on account of suspected lead contamination of its noodles.
Welspun India falls on account of problems with its customer Target, a US retailer.
These are just illustrative examples and there are surely more instances of big falls in stock prices.
The question that arises is: what should be done? Is the fall giving an opportunity to become the next Warren Buffett or will the stock make the investor a Bill Miller?
Unless you own the stock, you are not forced to decide what to do with it. If you hold the stock, you are forced to choose between holding, buying more or selling the stock. If you do not own the stock and are not certain what to do, you can always look at other stocks.
UNDERSTAND THE PRICE MOVEMENTS
Just because a stock has fallen doesn’t mean it’s attractive. As a smart investor had pointed out, “A stock that falls 90% from peak is one which fell 80% and then halved further.” If you thought the stock was attractive just because it fell 80%, you could have lost 50% of your money buying it then.
Stock price movements are just that. Price movements. A company’s sales and profits do not depend on stock price movements. If on a fundamental business basis, the fall in stock prices is irrational, it may offer an attractive opportunity to buy the stock.
In order to arrive at a conclusion regarding a company, the following have to be satisfactorily answered.
Will the company survive a crisis? This was the difference between American Express and Lehman Brothers. The former survived while the latter did not. Sometimes the answer to the question is clear.
Whether it was about alleged lead residue in a brand of popular noodles, or pesticide in cold drinks or worms in chocolates, it was clear that once the respective company undertook remedial measures, the products would be back on the shelves, and that consumers loved the products.
On the other hand, where it is something like Winsome Diamonds or Kingfisher Airlines, where there are huge defaults to lenders and apparently hardly any assets, it is almost clear that the company will not survive.
Many a times there is uncertainty. Satyam Computers was such an example. Often it seems that the company may not survive whereas eventually it does.
As mentioned earlier, unless one is holding the stock, one is not forced to take any action.
If the answer is that the company will survive, the subsequent question is: will the customers come back?
Often, the answer depends on whether there was systemic wrongdoing by top managers or whether the company was a victim of external fraud or circumstances. Thus, a regular product recall (say, for a car) due to a faulty part is not as serious as, say, systematic cheating on pollution data by the car manufacturer.
Where the involvement of top management is established, it will help if there is a complete overhaul of the governance structures. Usually, customers and regulators are tolerant about genuine errors but crack down heavily on wilful wrongdoing.
In conclusion, a steep fall in a stock price is not a cause to blindly purchase a stock. Questions pertaining to survival and customer loyalty have to be clearly answered. For most investors, discretion may be the better part of valour.