Stock Market Downturns: What You Need to Know by Chris Gilbert

Market downturns are one of the few guarantees in investing. At some point, stocks you own will also experience a decline for one reason or another. It can certainly be an unsettling feeling. It’s human nature to let doubt creep into our minds. Did we do enough research? How far will it drop? Don’t worry, today we’ll discuss different types of bad news, decipher how it affects stocks, and learn what to do when your investments encounter inevitable declines.

Stock Market Downturns: What You Need to Know

Talking Points

  • The value investor’s philosophy on market downturns
  • Understanding potential causes
  • When to buy, when to sell

Value Investing Philosophy Regarding Market Downturns

At some point in time, your investments will encounter a swift decline. Maybe with due cause, maybe not. Stocks, and the stock market for that matter, often behave irrationally. According to the Efficient Market Theorists, stocks are always priced equal to their value. However, value investors know this to not be true, and many have the results to prove it.

“In the short run, the market is a voting machine but in the long run, it is a weighing machine.” – Benjamin Graham

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Benjamin Graham, the father of value investing, knew this. As his quote above states, the market can rise and fall in a matter of minutes for any reason, but in the long run, it evens out and the best businesses end up on top. This is a critical point because it helps value investors see clearly when everyone else is dumping their entire portfolios.

That being said, there are valid reasons for a stock to decline and investors need to be able to distinguish this. After all, the whole point of investing in stocks is to achieve solid returns, and if you're holding on to a sinking ship... you might be in trouble. So, let's take a look at some possible causes for a downturn and what to do if it happens.

Understanding Potential Causes Of Stock Declines

Declining stock prices can be worrisome, but if you better understand the cause, or potential event behind the drop, it gives you a better idea on how to act next. Since there can be many precipitating factors, I've decided to lump them in two broad categories: company issues and market issues.

Company Issues

  • Fundamentals - The first factor to consider is the overall health of the company. Is there too much debt? Too little cash flow? Did sales drop drastically? These are all metrics that need to be monitored at least quarterly anyways. The company's health and fundamentals are by far the most important issue to consider. After all, it's part of the reason you invested in the company. If you see sagging fundamentals, too much debt, or an overvalued business... it may be time to reconsider your investment.
  • Events- Every now and then an "event" can happen within a company that leads to significant sell-off. Lumber Liquidators and Chipotle are recent examples. These "events" can lead to quick declines in stock prices. When confronted with these situations, ask yourself 3 questions. Do the fundamentals look any worse after the event than before? Does the event prevent the company from increasing sales/earnings? Is management handling the event properly? If the answers are no, no, and yes... then you needn't worry. There's also a need to analyze the event in a broader aspect as well. For instance, could it lead to lawsuits, fines, or other problems further down the road. These are probably the trickiest type of issues to resolve.
  • Management - What happens when your favorite company, which has given you excellent returns, has a change in management and suffers a price decline. Most of the time, if the company had solid management, they ensure the next group is just as capable. However, if you see a swift exit of several top employees for no apparent reason, there could be bigger problems. Sometimes a key figure can leave and change the entire vision of the company. It's key to follow what the new management says. And even more important to watch their actions and determine if they match.
  • Missed Earnings - The dreaded earnings miss. Analysts have a tendency to lose their mind when a company falls short by an entire penny (sarcasm), but should you? When in doubt, do the complete opposite as the analysts. Partially kidding. However, you should never buy or sell a stock due to earnings or guidance expectations. Instead refer to your intrinsic value and analyze the company's fundamentals. If you feel everything is in order, you shouldn't worry.

Market Issues

  • Market ValuationSometimes the entire market, or specific industries, may become overvalued. I have made a spreadsheet specifically designed to help you determine this here. These "bubbles" usually lead to a stark decline in stock prices. You can avoid these crashes by keeping a decent amount of your portfolio in cash when you feel the market is in a bubble and staying away from overvalued stocks . In the event you do experience a crash just remember, you're investing for the long term. Don't dump an investment because an entire industry, or market, is crashing. Instead, look for opportunities that might be created.
  • CompetitionA true concern, and one that is often overlooked until it's too late, is simple capitalism. Successful companies, and industries, lead to intense competition. Every now and then a company comes in and completely disrupts entire sectors (think Netflix or Amazon). It's not something to take lightly, especially if it's affecting your investments. If a company comes in and disrupts sales or earnings, it can bankrupt businesses in no time (Blockbuster). In these cases it's extremely important to be vigilant of fundamentals and management. If one starts to teeter, investigate.
  • Regulation There is a compelling argument for an inverse relationship between the stock market and the Federal Reserve's interest rate regulation. When the interest rates are raised, stocks move down. When they are lowered, stocks move up. In other words, when people can get higher interest rates in "safer" vehicles (T-Bills, CDs, etc.), they tend to move their money out of stocks. But the value investor shouldn't be enticed, nor deterred, by the ever fluctuating interest rates. Remember, in the long run stocks beat every other type of investment.

When To Buy And When To Sell

Now that you have a better understanding on different causes of stock declines, what do you do? Buy more, hold steady, or sell as fast as you can? Let's discuss.

Buy

There is really only one time you ever buy stock in a company - after you've performed diligent research, analyzed fundamentals and management, and determined an intrinsic value. But that's not all. You have to calculate a margin of safety that you would be comfortable with before you buy a piece of the business.

Of course you should take into account why the stock is falling. Analyze the scenario and understand it. If you come to the conclusion the market is acting highly irrational, as it often does, then review your original assessment and see if anything has changed. If it still looks like a strong, well-managed company, then look into adding to your position.

Sell

Let me be clear however, I'm not advocating you go out and load up on any stock that's tanking. If the stock is down or in decline, there is usually a reason. Whether that reason is a rational fear or not has to be determined. Which is why it's vital to understand the scenario.

If you determine the reason is a long-term, concrete issue that affects the company's future, then it may be time to sell. But thorough research and valuation still need to be done. After all, that is the definition of value investing. Buy when the company is undervalued, and sell when no longer attractive.

This is an important distinction and critical to understand when it comes to selling stocks. You don't need to wait for the company to become overvalued to sell a stock. If the business is no longer growing or encounters one of the problems mentioned above that drastically alters its future, then it's time to look for other opportunities. However, the only way to determine this is to analyze the company's underlying fundamentals and calculate an intrinsic value.

Summary

  • Stocks fluctuate in price all the time - sometimes caused by irrational fears and other times for legitimate concerns
  • Value investors are diligent and do proper research to better understand the causes of these declines
  • This allows us to be properly knowledgeable about what to do next and act with a level head
  • The bottom line on buying or selling in these situations harkens back to the basics of value investing - analyze fundamentals, determine an intrinsic value, and calculate a margin of safety

About Chris Gilbert

I am a full-time pharmacist as well as an avid investor. I discovered the art of value investing by reading the works of Benjamin Graham. After that I began to drift towards Peter Lynch, Warren Buffett, and Charlie Munger. My investing philosophy now is simply to find great companies at a discount while using a common sense, value oriented strategy, and maintaining a long-term outlook. I am determined to educate the individual investor that investing is not hard, not time consuming, and not expensive. Through the use of value investing and the (Y)OURPORTFOLIO Spreadsheet, my goal is to help you obtain better results in a fraction of the time.

Website and Blog - yourportfoliospreadsheet.com