You've been watching the stock of a global industry leader. The three-year bear market has taken its toll on its share price. But overall the company remains sound, or so you believe, with a strong diversified revenue base. Moreover, it's in a defensive sector and is paying an attractive dividend. Of course, the company isn't perfect, but any problems seem small and manageable, especially given the company's strong leadership and franchise dominance.
So you sprinkle shares in client accounts.
Then, one morning, the stock crashes through your stop-loss orders on unexpected news of a huge earnings restatement. Shares are now worth 30 percent of what they were at the end of the last trading session. You couldn't possibly have seen such a collapse coming — in fact, few did. And you couldn't have sold out before it cratered anyway.
A doomsday scenario? Hardly.
This sort of nightmare is occurring with frightening regularity; the most recent debacle was Ahold, the Dutch-based supermarket chain. Ahold, available to U.S. investors via American depository receipts trading on the NYSE, had been known for its shrewd, conservative growth strategy that had turned the Dutch food group into the world's third-largest food retailer, with operations in Europe, Latin America, Asia and the United States (under the Giant and Bi-Lo names). Then, one day Ahold management said that it would have to restate earnings over the last two years by at least $500 million, which sent the shares in a freefall, plunging 60 percent.
The sudden destruction of shareholder wealth — especially your clients' shareholder wealth — puts you, the rep, in a pretty tight spot. That is, it makes you look stupid and inept. You have to ask yourself, “What the hell happened? And what's the best course of action now?”
“Discerning whether there has been a material breach to the underlying investment thesis is essential,” says Kevin Marder, chief investment strategist of Ladenburg Thalmann Asset Management in New York. Marder believes that, when it comes to clients, bad news can't wait. “It's essential that they hear from you ASAP,” he explains. “And if you determine that financial transparency is gone, it's probably best to get out.”
Steve Saker, vice president of the Orlando-based International Assets Advisory, recommends that once a stock has collapsed, your action should match your client's sentiment — no matter how strongly you feel about an eventual rebound. “For conservative investors, immediate liquidation is probably a sound move, getting out before further revelations are made, enabling investors to take advantage of the tax loss.”
For investors with moderate risk tolerance, brokers do have the option of praying for a rebound — and then getting out. Saker notes that “stocks that suffer such cataclysmic collapse often overshoot a reasonable valuation. This suggests that once the initial shock waves have dissipated, shares could rebound 10 to 30 percent.”
For more daring investors, once an initial bottom is made, adding to the position could help recoup a significant portion of the loss. But this is very risky business. After all, stocks that collapse can collapse some more. It isn't uncommon for shares of the suddenly awful to blow right through stop limits, forcing your client out at significantly lower levels.
“Deciding to remain invested, hoping for some kind of upswing must be based on assessing whether the crisis was triggered by systemic operational problems portending additional bad news or a one-time event,” posits Erik Olsen, head of research at the New York-based money manager advisory Munn, Bernhard & Associates.
When Tenet Healthcare's shares fell from $39 to $29 in a single day last October, fear ripped its shareholders, as investigators began a probe of two doctors accused of having performed unnecessary procedures.
Such accusations could have been regarded as an isolated event. But other doubts were being raised by an analyst claiming Tenet was bilking the government. While nearly all other analysts were dismissing this concern, this allegation proved to be the undoing of the stock. A week later, it lost an additional 50 percent in a single day. The company subsequently admitted it needed to price less aggressively, altering its profitability and rating. And this prevented the stock from rebounding.
Trying to discern the real meaning and depth of an accounting problem, an earnings miss or even outright fraud is very difficult for brokers. Reps rely on research by the same analysts who were taken off guard in the first place. So the ability to regain any level of transparency over the near term is highly unlikely.
Accordingly, David Ryan, who runs his own hedge fund, Ryan Capital Management, believes in immediately taking half the money off the table after a big decline. “Because of the lack of visibility, there is no way to know whether holding or selling off completely will be the right thing to do so I split the difference,” explains Ryan. “And if I don't see at least a 15 to 20 percent bounce in the next several days, then I'll sell the rest.”
If a bounce does occur, he carefully watches the stock's action to see if the market believes the trigger was a one-time event or reflection of a fundamental change in the company's outlook. When AMN Healthcare Services lost 20 percent one day last August, true to form, he sold half his position. Shares made up the loss in the following three weeks, but on only half the normal volume. When the price started to break down again, he immediately sold out. And today, the stock is trading at half that price.
Last October, Veritas Software lost nearly 25 percent of its value when its CFO admitted lying about having earned an MBA from Stanford. Nearly 64 million shares were traded that day, five times the normal volume. The stock quickly rebounded, rising 80 percent on the back of the year-end tech rally.
One lesson of today's volatile market is to set very tight stop-losses so as to get out on the first sign of trouble, which usually precedes a collapse. “Preserving capital should always be the foremost concern, especially today with so many clouds hanging over the market,” says Marder. He personally sets stop-losses at 5-7 percent below purchase price. This practice is rooted in the belief that price moves usually foreshadow changes in a company's fundamental outlook.
If a broker doesn't feel comfortable pulling such a quick trigger, put options can be a relatively inexpensive means of hedging a long position. But if your clients have taken a hit, Olsen offers the most compelling case for quickly exiting a troubled position. He observes that companies that loose tremendous market value might often find themselves scrambling to sustain financing. This means that companies, like Ahold, who had driven earnings growth through expansion must now turn 180 degrees, looking to sell off assets in hopes of boosting the bottom line by cutting debt. “Such a decisive change in business strategy,” Olsen explains, “is likely to portend a long wait before the company may hope to reclaim the investment thesis that had once made it a compelling buy.”