What Should You Do When A Stock Plummets... Buy, Hold Or Sell?

4th Feb '15 by Edward Croft

29 comments 23156 reads

One of our subscribers today (dangersimpson ) sent me a marvellous piece of research by Michael Mauboussin entitled “Managing the Man Overboard Moment - making an informed decision after a large price drop". The insights contained in this piece hold some great lessons for all stock market investors. He shows how to decide whether to buy, sell or hold stocks that suffer from negative news and 10% price drops by analysing just a few key factors of a stock which will be strikingly familiar to Stockopedia subscribers.

For those who don't know Mauboussin, he's the Head of Global Financial Strategies at Credit Suisse and a prolific writer - his several books on skill, luck and decision making come highly recommended. We admire him due to his rigorously rational, data driven & analytical mindset - the kind of mindset we believe investors should all apply to stock markets in preference to intuition or gut instinct.

The power of the checklist investor

Mauboussin begins his paper by explaining that the key to successful investment is keeping emotions in check when facing adversity. Days when widely held stocks like Tesco (LON:TSCO) have fallen by 10% or more have led to outpourings of grief and emotion on bulletin boards across the web. Private investors rarely if ever seem to know what to do in these situations - with a classic example being seen in the aftermath of a profit warning by widely held small cap Xaar (LON:XAR) - the Stockopedia forums were rife with differences of opinion and confusion. So how, we ask Mauboussin, can we keep emotions in check and make the right decision amidst uncertainty?

The high technology he proposes is - surprise, surprise - the simple checklist. Mauboussin says - “If your state of emotional arousal is high, your capacity to decide well is low. A checklist takes out the emotion and moves you towards a proper choice."

Building a decision tree

Mauboussin compiled a set 5,400 occurrences where stocks had declined by 10% or more in a single day between 1990 and 2014. From this set he set out to discover the likelihood that a stock would recover from its fall over the next one to three months by profiling the characteristics…

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iwright7

5th Feb '15

Hi,
If we apply the Maubboussin "Earnings Event" flowchart using Stockrank numbers, to the Pressure Technologies (LON:PRES) profit warning (-35%) today, the interpretation I assume would be:

Value - 80 High
Quality - 68 High
Momentum - 49 Neutral

Therefore the Maubboussin average increase after 90 days = +11.4% So Hold or Buy Pressure Technologies (LON:PRES)

The problem is (and with Paul's BLASH buy at the low approach), is that who knows whether/when another profit warning will clobber the share price? I prefer the sound of the "Non Earnings Event" probabilty prediction. Ian

stupormundis

.. hmmm ... My problem with Creston solved .. price down 8% .. V93 + Q74 + M94 = hold which I was going to do anyway. What none of this deals with is the quote extraordinarily volatile age of low growth and skittishness in which we live,

Funnymoney

Ed,

Your screen uses one week price change - this is all about one day events. I can't actually see a way to screen for 1 day % changes though.

Regards

Edward Croft

Paul - I do disagree with a lot of what you say, and as they say - differences of opinion make a market. So here goes.

"The way people handle profit warnings actually exposes how they are really speculators, not investors at all"

This kind of sectarianism is v. v. unhelpful. Everyone is a speculator whether they like it or not. Some of the 'investors' I've most admired have made all their money from what more staid investors might call speculation. Successfully deploying capital is about what works, not an idealist fantasy of the 'right' way to invest. Rule #1 Don't lose money. If cutting losses and admitting you are wrong means you preserve capital, then it gets my vote.

"You just hunker down for a year, and then you get your money back."

"Buy and hold at all costs" bankrupted a tonne of investors in 2008. Hanging onto losers also creates a massive opportunity cost... if a stock is suffering from poor recent momentum then sitting on it for a year means your capital is tied up in a loser. Why not rotate into stocks that have more probability of success ? Don't get stuck in losers.

Hanging onto losers also exposes yourself to a load of behavioural biases - the 'getting back to even mentality' has made more investors underperform than any other. The average investor underperforms by 6% per year - this kind of aversion to taking losses is one of the main reasons why. People have to learn to be less attached to their stocks not more. Learn to let go.

"You should buy on the spikes down, and sell on the spikes up!"

I'm from a different school of thought. Buy high and sell higher. Value investing works... but it can be very very lumpy in returns - often value investing can lead to underperformance for long time periods. Buying 'cheap' on its own can put you at the mercy of negative momentum - falling stocks tend to keep falling. Why not buy cheap stocks with rising prices? Value + Momentum together is a far more powerful combination. James O'Shaughnessy called it "Trending Value" and it was the most successful strategy of all in his excellent "What Works on Wall Street". The V+M strategies have been amongst the best on Stockopedia.

Buy the dips... sure... but buy the profit warnings?

For those that are interested - Paul and I will be bantering together at the ShareSoc Masterclass on Feb 25th in London - there's just a few tickets left http://www.sharesoc.org/masterclasses.html

Funnymoney - yes - you have to sort by the days' price change - it's one of the columns in the table. We are working on intraday screening but it will be a little time yet before we can merge it with fundamental screening.

Mark Simpson

Hi Paul,

With small caps, every situation is unique. So there is no formulaic way to respond to profit warnings. Try to find one, and you will forever be banging your head against a brick wall! It's part art, part science.

Unless you are following a purely quant strategy then this is always the case. But it is also almost always better to be swimming with the tide than against it. You are almost always better in the long term by restricting your investments to high quality value stocks (even more so for small caps, see: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2553889) and selling when they cease to be good value or high quality. Or buying high momentum stocks and selling when that momentum subsides. The reason is that even if you don't have 'alpha' you at least capture the best 'smart-beta' that you can, whereas to generate decent returns buying expensive junk you really have to have a very good stock-picking 'alpha'. In reality very few of us have sufficient stock-picking ability over the full business cycle to overcome this headwind which is why a lot of the long term successful investors tend to be value-based.

It is the same with this guide. If you have genuine 'alpha' in these situations by knowing your stocks better and being able to put aside any emotional response or bias then you are better off using your judgement not this checklist. However very few people have the ability to behave completely rationally when stocks are dropping rapidly and would be better off simply accepting that they should swim with the tide of historic responses. Of course that doesn't mean that every stock will perform as per the historic average (just as every value stock doesn't earn exactly the value premium over the index every year) just that the historic response would be a good baseline to use to guide your decision-making in times of high uncertainty.

Cheers,

Mark

MichaelFBS

Thanks for this Ed. It has generated quite a discussion probably because, along with when to sell, what to do after a sharp decline is one of the things that is really hard to get a handle on.

I was in the process in reading the article as I came across your report of it. I am still in the learning process and am currently reading (is that wading through - it is pretty hard going) Security Analysis but so far my take on how one should react to/control ones reactions to sharp price falls are:

1. Deal only out of hours - this will prevent panic hitting of the sell button. Guy Spier

2. As Paul says wait at least two or three days, which has the similar effect to the above.

3. When you but a share buy it with the view that you are not going to sell it for two years. In this case the fall becomes irrelevant - Guy Spier

4. Re-assess the reason you bought the stock and if the reasons still stand do nothing or

5. Having re-assessed and if the reasons for buying are still valid then Buffett would say buy more because the shares have just gone on sale. My experience over the past few years would indicate that this is correct: My examples are

Air Partner (LON:AIP) I was in profit, then dropped 25% below my purchase price, now recovering
Pittards (LON:PTD) dropped about 30% and recovered about half of that
Dart (LON:DTG) dropped from 250 to about 180 but has now recovered to put me in profit by 25%
Vislink (LON:VLK) dropped about 30% and is now at break-even for me

I now have to decide about John Menzies (LON:MNZS) which has more than halved from its peak and is now offering a PE of 7.5 and a divi yield of 7.47. Any thoughts would be welcome.

Another story I have just watched (on YouTube at http://goo.gl/HPAo3m) Buffett related was about Coke. This stock floated in 1920 for $40 a share. The next year it had halved in price and was trading at $19. But if one had held the stock till when the speech was recorded (1998) your one share would be worth $5m.

So in my humble opinion if you have bought a share for the right long term reasons and those reasons stand then one should hold and probably buy some more.

Rusty2

Hi Edward,
I understand that some companies sp goes up and up, can't think of any off hand. But what about normal companies whoes shares do go up and down. Lets take one that seems well regarded around here: ZYT, now they had a profit warning about mid last year down from about 240 to 200p, so you would not buy then but when would you buy? You say after the sp has risen but by how much? When its reached the pre crash level? To say don't invest in companies that have profit warnings I find surprising as that excludes some of the top rated companies on Stockopedia like Dart.

Herbie - I'm not saying do anything. I'm just saying what I do and sharing what the statistics tell me to do. What you should do is entirely your own decision.

I've given my perspective on profit warnings before. I steer clear for some time after the event as share prices tend to continue in the prevailing trend of the surprise.

There's been plenty of research on this and it's a key hedge fund trading strategy - stocks that disappoint tend to keep disappointing, stocks that surprise to the upside tend to keep surprising to the upside. That's momentum and I hate fighting it. Momentum is more powerful than value - it works over shorter time frames - especially over 3 months to a year - while value works over longer time frames.. one to two years.

If you look at ZYT (not a company I know at all) there was a huge fall in May 2013. Surprise surprise that 6 months later it was still bobbing around at the same level. There's an opportunity cost right there - 2013 was a rip-roaring year for stocks and owners of ZYT just sat there for 6 months without participating.

When is the right time to get in to a stock? Risking being scolded by all the value investors out there... I prefer buying high ranking breakouts in my discretionary trading account (which is a smaller part of my capital - i.e. the adrenaline part). Yes - that makes me partly a chart reader.

For ZYT - a quick scan to me suggests the best time to have bought it was on the broker upgrades and price breakout around the 10th September last year - there was a big volume spike and price breakout in a high ranking stock - timing + ranking == perfect. And over a year since the huge fall / profit warning so plenty of water under the bridge. It actually looks like a classic case study from some of my favourite books.

54d3993c6296cZYTRONIC_Share_Chart___Live

Buy high, sell higher is a very well known strategy to those who have read people like Nicholas Darvas & Gerald Loeb & Jesse Livermore. I'm a huge fan of Bill O'Neil who was influenced by all of them - and highly recommend reading his great book. http://www.amazon.co.uk/How-Make-Money-Stocks-Winn... It could forever change the way you view investing... his philosophy is buy high, sell higher... & not to worry too much about valuation & use strict stoop losses and risk management. I classify his strategy as a QM strategy... it works - QM (quality + momentum) has been the best strategy amongst all our ranking factors. QM is especially fun for trading as you focus less on the grubby value stocks - and everyone needs a bit of high growth glamour to get through the day.

@ purpleski Paul Scott did a review on Menzies quite recently. He thinks the div will not be maintained.

My view on those 5 is 3 are in the aviation sector, I would probably be looking to sell one. My view is ignore what you paid for them and look at each one as if you are going to buy them, see which has the most potential. IMO AIP, Dart and Vislink (which I hold) look OK, PTD rating has dropped, MNZS does not look that exciting. Dart Im considering to buy but maybe also Gama or I may look into AIP now.

Hello Edward,
Yes I know you were not saying do anything, Im just trying to understand your strategy which is different from Paul's. So your strategy is more short term? How do decide when to sell?

cig

Behavioural biases work with momentum too, for example, someone who buys a momentum stock may not sell when the momentum stops, or the value is realised, because they see a positive PnL and so are content to hold when the original investment case is gone.

Pure momentum is also a strategy that tends to work okay for long periods with occasional but brutal reversals, that many people can't cope with. That may be the main reason why the factor persists: because most people can't cope with it over a full cycle (unlike unemotional computer back tests).

Besides momentum is by nature short(ish) term, so requires frequent rotation, which are costly in small caps. For example, what is the performance of a market neutral portfolio which is short top decile QV stock rank and long top decile QVM stock rank (so as to measure the incremental alpha of your M)? Is it positive enough to justify transaction costs?

Im not convinced that momentum are quicker than value. I have bought some value stocks like OPAY which went up over 20% in a day, which I sold, 280 - 340. I have had momentum stocks which then have soon peaked and fallen back below what I paid. Other value stocks I can mention lately are Tesco, Xaar, Hunting, Asos, QPP, Royal Mail, BG, BP all have gone up over 10% in short time, in fact some are up 30% in a few weeks. I suppose after a while they become momentum shares but look many have slowed down, or dropped back. I think momentum is good for some shares.

I have different buckets for my capital which are spread in different strategies. The majority is slow QVM or GARP or QARP - however anyone wants to categorise it. I've learnt to be very systematic, and unattached as it works for me - I don't want to spend my life like I used to - with a highly concentrated portfolio and the emotional rollercoaster that goes with it. I'm happy with a more diversified, slower but surer method that rarely fail over longer time frames.

But as a human it's very hard not to have an outlet for the side of the psyche that likes risk. Rather than it being my entire folio - I keep a smaller element in spread betting accounts that I trade - and I prefer to do it in QM stocks as explained above over shorter time frames.

As years have gone by I've found methods that work for my own psychology. Half the battle is knowing yourself and avoiding becoming overconfident - I'm still figuring that out but I'm getting a lot better at it. Treating my portfolio like a pyramid - with a safer, systematic majority and a smaller higher risk, discretionary minority is a good balance - works for me and allows me to experiment without gambling the house.

DLG12

Excellent thought provoking discussion, thanks. I am currently trying to work out what to do about the declining value of my Tungsten holding, so useful food for thought.

pka

6th Feb '15

Another approach is to emulate fund managers Nick Train and Terry Smith and buy a portfolio of undervalued high quality companies and holding them forever (or at least for many years), ignoring any profit warnings or share price drops when they occur. This approach seems to have worked very well for them, as their funds have consistently outperformed the FTSE All Share Index.

Yes very interesting discussion, have learnt quite a lot. Anyone have any views on Robbie Burns (Naked Trader) stategy, which is buying good value stocks and selling if they go up about 20-30% with a stop loss around 12-15%, seems to work for him.

His performance may come from the "buying good value" bit and not the arbitrary take-profit/stop-loss range. Unfortunately the former is harder to reproduce than the latter.

7th Feb '15

Herbie - we've been modelling the 'quant' side of the Naked Trader strategy for about the last 3 years. You can see the performance here... the UK version is up about 100% on a 25 stock portfolio. http://www.stockopedia.com/screens/naked-trader-es...

54d5d1269494bNaked_Trader-esque_Screen_-

The average stock in the Naked Trader strategy has a Stockopedia StockRank of about 90/100. So it's very much a strategy that picks the kind of good, cheap, improving stocks that tend to beat the market.

I repeat myself a lot, but historically speaking, the most optimal stock market strategy exposes itself to stocks that have certain factors in common:

they tend to be moderately priced or cheap (value stocks),
they tend to have rising prices (momentum)
they tend to be profitable (quality)
they tend to be low risk (low volatility)
(Apple aside) - they tend not to be mega caps (size)

Much like the Zulu Principle strategy - Robbie Burns's strategy is exposed to many of these factors systematically. Professor Robert Haugen called the kinds of stocks that share these attributes to be 'super stocks'. You can read up about how our StockRanks system is based on many of these factors in this article. http://help.stockopedia.com/knowledgebase/articles...

Anyone who wants to learn more about this stuff should join the webinar on Tuesday - http://www.stockopedia.com/webinars/

AlanJenkins2

30th Nov '16

Ed,the thing that I cannot quite get my head around is this.I buy a highly ranked stock,and occasionally,it may have a profit warning - a hazard of hunting for value,as you have said.The share price falls steeply.Now the overall stock rank is just outside of the top decile,but only because of poor momentum - its value and quality rankings are still high.Should I sell ? I wouldn't remotely consider buying a stock if its quality and value rankings weren't good but it had fantastic momentum.

I can guess that part of the problem here is that the profit warning itself cannot be reflected in the historicals until it has translated into poor results.So what then if the situation was similar but there was a poor set of results with no prior warning,so it is reflected ?

What should you do when a stock plummets... buy, hold or sell?

The power of the checklist investor

Building a decision tree

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Edward Croft

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