Strategies for Assessing a "Loser" Stock (The Permanent vs. Temporary Problem)

 

Strategies for Assessing a "Loser" Stock (The Permanent vs. Temporary Problem)

The core challenge in managing a losing stock is distinguishing between a temporary setback (which may be a buying opportunity) and a permanent, structural deterioration of the business (which requires selling).

Here are the key strategies for assessing whether a declining stock is a loser to be sold, or a high-quality asset on sale:

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1. Re-Examine the Original Investment Thesis

The single most important question is: Have the fundamental facts that led you to buy the stock permanently changed for the worse?

• Temporary Problem (Hold/Buy More): The price has dropped due to short-term, cyclical, or macro factors (e.g., a recession, general market panic, a temporary commodity price swing, a poor quarter due to a one-time charge).¹ The long-term earnings power and competitive advantage are still intact.

• Permanent Problem (Sell): The price has dropped because the core reason you invested is no longer valid. This includes:

  • Loss of Competitive Edge (Moat Erosion): A key competitor has introduced a disruptive technology that fundamentally threatens the company’s business model.

  • Industry Obsolescence: The entire industry is in secular decline (e.g., Blockbuster video).

  • Major Management Change: Key leadership that drove the company's success has unexpectedly departed, and the replacement lacks vision or competence.²

2. The Fundamental Red Flags (Signs of a Value Trap)

A "loser" stock that keeps falling often turns out to be a "value trap"—a stock that looks cheap by traditional metrics but is cheap for a very good reason.³ Look for these fundamental red flags in the financial statements and operations:

Red Flag	Financial/Business Metric to Check	Implication (Permanent Deterioration)
Deteriorating Profitability	Declining Revenue Growth & Margins: Is the company consistently losing market share or is it unable to pass on rising costs to customers?	The core business model is breaking down.
High Financial Risk	Debt-to-Equity Ratio / Interest Coverage: Does the company have excessive leverage that puts its survival or future dividend payments at risk?	The company may struggle or fail in an economic downturn.
Poor Capital Allocation	Return on Invested Capital (ROIC): Is the management failing to generate sufficient returns on the money they reinvest back into the business?	Management is compounding bad decisions and destroying shareholder value.
Management Credibility	"Over-Promising and Under-Delivering": Has the management repeatedly missed its own financial guidance or engaged in aggressive/opaque accounting practices?	Lack of trust and competence, which is almost impossible to fix quickly.

3. Compare Against Benchmarks and Peers

A stock that is down 10% in a month might not be a loser if the entire sector is down 20%. Context is vital:

• Benchmark Comparison: Review the stock's Total Returns (including dividends) over 1, 3, and 5 years against a relevant broad market index (like the S&P 500) and your expected average annual return (e.g., 10%).

• Competitor Comparison: How is the stock performing relative to its closest peers? If your stock is down 15% but its main rival is up 10%, the problem is almost certainly company-specific and likely warrants a sale.

4. Psychological and Portfolio Discipline

Recognizing a loser stock is also about overcoming behavioral biases:⁴

• The Sunk Cost Fallacy / Disposition Effect: Investors tend to hold onto losers too long (hoping to break even) and sell winners too early (fearing a fall).⁵ This is the exact behavior the principle advises against. Selling a loser is an acknowledgment of a mistake, which is psychologically difficult but necessary for preserving capital.

• Better Opportunities Exist (Opportunity Cost): Ask yourself: "If I had the cash from this losing stock right now, would I buy this stock again?" If the answer is no, sell it and reinvest the remaining capital into a position that you have high conviction in.

• Tax-Loss Harvesting (The Silver Lining): In taxable brokerage accounts, selling a loser allows you to harvest the capital loss to offset capital gains realized from your winners, thereby reducing your tax liability.⁶ This can make the emotional pain of realizing the loss easier to swallow.

The final decision should always be based on objective fundamental analysis—the deterioration of the underlying business—and not the mere fact that the stock price has fallen

Invest like Buffett - Hold on to your Winners Forever

Best holding period is holding forever.
Sell your losers, hold on to your winners.

SELL THE LOSERS, LET THE WINNERS RUN.
Losers refer NOT to those stocks with the depressed prices but to those whose revenues and earnings aren't capable of growing adequately. Weed out these losers and reinvest the cash into other stocks with better revenues and earnings potential for higher returns.

< I suggest this video: http://www.youtube.com/watch?v=WVqyCRYBieI >
Newbie
on 4/7/13

Thanks to Newbie for highlighting this video to me.

It is the selling of losers that is the wealth-maximizing strategy!

Many investors will not sell anything at a loss because they don't want to give up the hope of making their money back. Meanwhile, they could be making money somewhere else.


So, do you behave in a rational manner and predominately sell losers, or are you affected by your psychology and have a tendency to sell your winners? 


This is not a recommendation to sell a stock as soon as it goes down in price - stock prices do frequently fluctuate. Instead, the disposition effect refers to hanging on to stocks that have fallen during the past six or nine months, when you really should be considering selling them. 


Don't hang on to chronic losers! Not only do you lose, but you also lose the out on opportunities to gain. If it's broke, fix it!

It is the selling of losers that is the wealth-maximizing strategy!

Ref:

Emodons Rule

Differentiating between the winners and the losers

Differentiating between the winners and the losers

By Clyde Rossouw, portfolio manager of the Investec Opportunity Fund and Absolute Balanced Fund

Local and international stock markets have rallied strongly. Many investors are wondering whether this is going to be sustainable or whether equity markets will plunge again. What’s most encouraging for us as long-term investors is that we still see many good opportunities locally and globally, which we are exploiting. The recovery in the equity markets does not signify the start of a long-term sustainable bull market, but there is an opportunity to make money from deeply discounted levels on really good shares. As an investor this is a fantastic time to be sowing rather than to be looking to reap. The time for reaping will come later; investors just need to be patient.

Global stock markets bottomed in March and that changed the direction of world equity market returns. Once the bottoming-out process was confirmed, investors were prepared to start taking on a lot more risk. We have seen emerging market currencies appreciating and the rand in particular has strengthened substantially – even reaching a level of below eight rand to the dollar.

Where is the recovery coming from?
There have been massive stimulus packages around the world and investors are starting to realise that the world is not going to come to an end. Emerging markets are generally in better shape than the developed world. The Chinese government has embarked on a huge spending programme to support its economy and we are starting to see more favourable economic data from China. Steel and iron ore production is increasing and China’s purchasing managers’ index (PMI) remained above the critical 50-point level in May. The Chinese stock market has done very well over the last six months, together with India, Brazil and Russia. The South Africa stock market also enjoyed excellent returns, and support from foreign investors has largely contributed to rand strength. Rising dollar prices for commodities such as copper, platinum, gold and oil signify that the world is on a recovery path and emerging markets are benefiting from this trend.

The era of a commodities super-cycle is over
The uptick in commodities has resulted in local resources shares outperforming the general market. There are a number of opportunities within the resources space, but some companies still look very risky. It is unlikely that we will ever experience a commodities super-cycle again. The super-cycle commodities trend reminds one of previous market themes such as the “new economy versus the old economy” and the “tech boom” – which are now dead and buried. When the technology bubble burst, many of the tech companies ceased to exist, but the stronger companies survived. The same scenario is likely to play out in the resources space. Some of the more marginal companies will underperform or go bust, while quality companies will power ahead. It is clear that the performance of commodities versus commodity producers will be divergent going forward.

The current environment presents many challenges, but offers good rewards for those portfolio managers who make prudent stock selections. In a bull market when a theme is strong, investors just need to ensure that they are part of that theme and ride the wave. This luxury does not exist under current market conditions. The market is going to be much more cynical and will do its homework properly in terms of differentiating between the winners and the losers.

Physical gold is more attractive than gold companies
Gold shares have been very volatile – we saw a sharp drop in April and a strong recovery in May. Gold producers’ earnings benefited from the weak rand in the first quarter, but the strength in the rand will mean that companies’ earnings will pull back again. The strength in gold shares does not seem sustainable. Since 1970 the rand gold price has outperformed gold shares. Gold production has been declining since the 1970s and it continues to bleed every year. Last year South Africa was down to 226 tons of gold from 1,000 in 1970. The gold companies are all trying to expand internationally, but their long-term health will still largely depend on the quality of reserves.

Developed market government bonds are looking very risky
The Unites States government and the US Federal Reserve (the Fed) have been on a spending spree over the last few months in a bid to support the ailing US economy. The US government has been issuing trillions of dollars worth of US treasuries (long-term government debt) to fund the fiscal stimulus packages. China has supported the US government by buying up a great deal of these government bonds that have flooded the market, together with other central banks and private investors. The Fed has also been mopping up the excess supply of bonds. Essentially, the Fed buys these government bonds by printing more money; this is known as quantitative easing. When risk aversion peaked, many investors piled into US treasuries as it was perceived to be risk-free. Consequently, US treasury yields remained very low. (When bond yields decline, bond prices increase and vice versa).

The strength in government bonds could simply not be sustained. Since March US Treasury yields have been rising, and in the last week of May the ten-year Treasury yield reached a six-month high. The weaker government bond market reflects investors’ concerns regarding the continued oversupply of bonds. More government bond auctions are on the way and with appetite for government bonds waning, the Fed will have to keep on propping the market up. The dollar has been losing value and inflationary fears have also driven Treasury yields up.

A key question is how long the Federal Reserve will be forced to support the government bond market and whether its actions will not have serious implications for inflation over the longer term? Essentially, money is being created out of nothing. This is not money that was created from people actually doing some work, performing a service or producing goods. Money has been printed without any economic activity taking place. Economics 101 would suggest that if you have more money chasing the same amount of goods, services or assets, ultimately you will have inflation.

The upside is that higher inflation could result in an improvement in company profits, which means better cash flows, enabling companies to pay off their debts. In turn, the risk of companies defaulting on their debt obligations would decrease, resulting in corporate bond yields coming down. (As corporate bond yields decline, corporate bond prices rise).

Local bonds are still pricing in risk, but listed property looks vulnerable
Local bond yields are still higher than international bond yields and because of this spread our market enjoys some protection against a sharp sell-off in international bonds. However, the local market may be too optimistic about a meaningful decline in inflation. Consumer inflation is currently running at 8% and the bond market expects this to slow to 6%. There is a risk that inflation may remain above the upper band of the Reserve Bank’s inflation target. The international environment for bonds will be one to watch closely over the next few months. Listed property would be the most at risk from a rising bond trend. The differential between the yields of listed property and government bonds in South Africa is too low, whereas in the developed world the spread is much wider. Investors are not adequately compensated for the risk of holding SA listed property.

There are many attractively valued equities available in global and local stock markets that should give strong real returns for investors with a horizon of more than three years. Some of these opportunities include MTN, which has attracted corporate buying interest and Afrox, where the market has assumed its business franchise has been decimated. We are still not finding reasonable risk-adjusted returns from either bonds or listed property, and continue to largely avoid these asset classes. Despite tough conditions, there are opportunities to outperform the market and we are confident of producing inflation-beating returns over the long term.


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