Wednesday 16 January 2008

How to tell when a share's price may fall

Instead of rationalising, sell the stock when trouble strikes the company and reassess the situation from a cooler distance.

"It's different this time" are the most expensive words in the investment business. They are a rationalization trap of the highest magnitude, particularly in reassuring yourself to hold on to a share when it's clearly better to sell it.

Confronting Reality

Although business situations are seldom if ever identical, success in business can be analyzed; patterns of managerial behavior are recorded, categorized, and taught in graduate business school classes. In the same way, there are common contributors to failure which are discernible in deteriorating investment situations. Following is a list of some of the danger signs:

  • Heavy promotion of the stock by management or agents
  • Projections of unusually strong/lengthy growth
  • Use of round numbers for predictions (e.g., 50 per cent growth, or a "$ 10-billion market")
  • Questioning the motives or expertise of reasonable doubters
  • Strong claims to being the best, unique or exclusive in a business
  • Defining the market narrowly so that, by definition, one is the leader
  • Ready excuses faulting outside forces when performance falls short
  • Lateness in reporting earnings (against either prior practice or SEC filing deadlines)
  • Change in outside auditors
  • Change in lead banker without improvement in interest cost and/or size of credit facilities
  • Substantial insider selling of the stock
  • Resignation of key officers or of directors
  • Sales or margins trends diverging negatively from those of the competitors
  • Inconsistent management statements
  • Identical (seemingly rehearsed) management statements
  • Stonewalling when trouble is obviously present.

Faced with some combination of perhaps three or four of the above, an investor can reasonably and prudently conclude that something is wrong and should get out of the stock. To insist that a particular combination of adverse events as seen in another situation can be fully repeated before concluding the stock is in trouble is naive, and probably costly.

Things do not get better by themselves. When a company's affairs appear to be deteriorating, even if certain negative events have not been reported, investors are well advised to assume the worst by projecting that the situation is likely to continue worsening.

The point is, investors should be looking diligently for disturbing similarities to other problem situations rather than watching for comforting differences. The objective is to detect trouble as early as possible, thereby preventing or limiting loss of one's capital. There is an analyst's clich� that the first earnings disappointment will not be the last.

Similarly, be suspicious at the first signs of any type of trouble. Unless a neutral or skeptical observer can be convinced that all is well, exit before things have a chance to become worse. Ask dispassionately whether, in light of today's facts, it is a good idea to buy now.

There is a real but subtle difference between the "this-time-it's-different" rationalization and "this can't be happening to me." If what is going wrong is like something that went wrong once before, there is probably a reason. Putting it bluntly, the same mistake has been made again.

Simply hoping that the same mistake could not have happened again, however, is just across the reality-denial border from "this is not happening." This indicates a need to deny that anything is wrong, a blocking of the pain caused by a mistake. And, of course, when a mistake is public knowledge (the broker knows, and at year's end the tax accountant will know, too) the distaste is all the more deep and embarrassing.

What usually happens in these situations is that the investor focuses in the wrong direction; he turns subjective and inward. But the reality is that whatever is happening (collapsing earnings, a dividend cut, executive stock sales or resignations) is happening to the company -- not the investor -- in the objective plane, entirely unconnected causally to this particular investor's current ownership of the stock. It is happening, period.

The personal internalization that says "it is happening to me" and eventually "this can't be happening to me" is a rationalization. Sometimes an investor grasps at the discernible differences from a disastrous past investment experience and uses them to tell himself shakily that it will be alright, it is not at all the way it looks.

Instead of rationalizing, sell the stock at the point in time when trouble strikes the company and reassess the situation from a cooler distance. Remember that things do not right themselves. And realize that some serious buying power from other investors will be required to get the stock back up to higher levels.

A smart investor asks this key question: If I did not own the stock, with today's knowledge would I be a buyer now? When trouble first appears, prepare for the worst. This includes developing a mental scenario of what other shoes might drop, how long it all will take to play out the situation and how the market will react to the problem.

The most important aspect of performing this mental exercise is to examine prior situations in search of their similarities rather than differences. Then from a big-picture standpoint, remember that history does repeat.

Excerpt from It's When You Sell that Counts by Donald L Cassidy.

Donald L Cassidy is a cum laude graduate of the Wharton School of Finance and Commerce at the University of Pennsylvania, USA and an analyst with Lipper Analytical Services.