One of the most frequent questions I get from readers is what to do when a stock’s price falls 30% to 50% and whether they should buy more, continue to hold, or sell to cut their losses. Tough choice… which is why it’s important to have a systematic and logical investment process to evaluate your investments if/when such an event happens.
So if you’re faced with this dilemma and you’re not sure what to next, here’s the three-step process I always use when one of my stock has fallen by 30% to 50%, or by any significant amount for that matter.
1. Find out what caused the drop
First, you need to find out the reason(s) that caused the company’s share price to fall by 30% to 50%, and evaluate whether the situation is a temporary or permanent one.
If the negative situation is temporary, then the company is more likely to be able to recover and it could present an opportunity to increase your position (or at least hold on to it). But if the situation is permanent and it looks highly unlikely that the company will ever be able to pull through, then the best option is to cut your losses immediately.
2. Are the company’s financials still intact?
Anytime a company’s share price falls by 30% to 50%, the next thing I check is whether the company financials are still intact. When I talk about this, I usually mean the company’s cash position and debt level. My preference is that a company should be in net cash position. The reason why I like to look at the cash and debt positions is because if a company has a net cash position, it has the resources to handle a negative situation better and is likely to recover faster. But if a company is in a net debt position, the debt may affect its recovery process. (Needless to say, a high debt level is also inherently riskier.)
There is one exception for a company with net debt – if its earnings are highly recurring. Therefore, if a company is facing a temporary setback, is in a net cash position and/or has recurring earnings, I would consider adding or holding my position. But if the company has no recurring earnings and is a net debt position, I would probably sell my stake in the company.
3. Is there an opportunity cost?
Every investment you make has an opportunity cost because you choose to invest in this option instead of another.
When you evaluate a company’s negative situation, ask yourself how long the company will take to recover from it. Will the stock bounce back in a year or five years? If it takes more than five years to recover, it might be better to cut your losses and invest in another company that has better immediate prospects over the next five years.
For instance, when the oil crisis happened in 2015, many oil & gas-related companies saw their share prices crash. The oil crisis was a temporary situation and the chances of these companies recovering is high (unless they took on too much debt and went bankrupt), but the duration of the recovery may be too long.
The cause of the crash in oil prices was due to an oversupply of oil. The oversupply could last for a long time and its hard to predict when the economics will turn. Hence, an oil and gas-related company may take more than five years to recover fully and you need to consider the opportunity cost if your money can be better invested elsewhere.