Have you ever had the feeling while looking over your investment portfolio that a stewardess might appear at any moment holding one of those passenger safety briefing seat belts, and a diagram detailing the nearest exits? There are times in the lives of investors that in retrospect you’ve realized you should have thoroughly read the investment portfolio safety briefing and heeded it’s warnings on preparing for a rough landing. However, as you probably well know, unfortunately there is no safety briefing for personal investors.
Though stock markets can be volatile most investors understand that markets must have periods of gain and periods of loss. Thus the familiar jagged line we call stock charts, without these stops and starts we would never be able to “buy low and sell high”. However there are times that markets adjust rather violently, we’ve all heard the news anchor delivering the stock market report, “in financial news, the Dow Jones Industrial Average dropped 300 points today.” Hearing news like that can make the most experienced investment professional cringe.
There are times when investors may need to liquidate a stock from their portfolio as quickly as possible. Even the worlds great investors have been known to kick a stock to the curb when market conditions create head winds that even the best of companies cannot overcome. If you were to take a moment and go to the web site GuruFocus.com ( http://www.gurufocus.com/stockpicks.php ), and click on the heading “latest picks summary”, you will find a list of investors such as Warren Buffett, Richard Drymen, Bill Miller, Edward Lampert, and George Soros, under each investor you will find a list of their recent stock buys and sells.
Common factors that can lead to these “market adjustments” include; geopolitical events, economic events, interest rate changes by the Federal Reserve, commodity prices such as the price of oil, and natural disasters such as hurricanes. These are only a few examples of the forces that can affect the market. Recently stocks associated with home builders, and home builder companies themselves have suffered terrible loses. These companies have felt the sting of basic supply and demand economics. Builders have overbuilt homes in the past few years, and thus have created a glut of homes for sale on the market. When supply exceeds demand prices of the product being sold usually fall. These falling prices directly affect the home builders bottom line, earnings. Without earnings a stock is like a powerless ship out on the sea, without the power of earnings the stocks of the companies in question typically sink.
More recently, some mortgage lenders have been caught indulging in the stock markets greatest sin, greed. Knowing that current lending practices would allow them to write mortgage loans to borrowers with less than stellar, or even passable credit histories, they proceeded to write large numbers of loans to these very individuals. Coupled with historically low interest rates, and lax lending standards several lenders wrote an abundance of sub-prime mortgage loans, these loans typically carry a higher degree of default risk. Many of these loans were approved without concrete proof of the loan applicants income.
As you might guess, many of these loans have recently gone into default, leaving the lenders holding the proverbial bag, or loss. In the past these sub-prime loans were bundled together and sold to other investment entities. However, now many of these potential mortgage investment buyers are no longer stepping up to the plate to purchase these bundled sub – prime investment vehicles, as they feel the risk of default on many of these loans is dangerously high. Several mortgage lenders have recently filed for bankruptcy or have reported revised forward earnings statements.
As companies that lend react to these recent events by strengthening the standard by which they approve loans, credit will become harder to attain. Companies who in the past were able to generate a short term cash infusion into their business by obtaining a low interest loan, may find it harder to obtain the funds they need to keep their company solvent. The risk is evident, especially for smaller companies, decreased access to credit could affect them adversely. Markets do not like this level of uncertainty, thus investors in those markets have little patience with regard to utilizing a watchful waiting approach, they prefer to just sell the investments that they have that are levered to these financial companies. The eventual stampede of the heard trying to vacate this market territory results in large drops in the market as a whole. Many investors simply prefer to get out of the market as a whole and place the majority of their money in solid investment vehicles such as government bonds.
How is the individual investor to know when to sell their stocks in uncertain market environments? Probably the best way to identify a stock that should be sold is to be actively involved with the stocks you own. Reviewing the companies earnings progressions, business practices, sales growth, and profit margins at least quarterly is a good practice. Reading the companies quarterly and annual reports, news stories related to the company, reports from brokerage companies, and transcripts from quarterly earnings calls will provide you with an ongoing understanding of the companies strengths, and weaknesses.
Additionally, it is also prudent to follow the companies competitors in a similar manner. Problems or concerns facing it’s competitors might provide you with early warning signs in your companies industry or sector. The proverb of keeping your friends close and your enemies closer would be a good analogy.
Here is a report on comments from the CEO of Home Builder DR Horton (March 2007) Earnings Confernce Call, “D.R. Horton, the second-largest builder by revenue, will likely miss its internal goals for 2007 home closings, Tomnitz said today. Closings will likely fall below 2006 levels, he said. “I don’t want to be too sophisticated here, but 2007 is going to suck, all 12 months of the calendar year,” Tomnitz said. “Our future is not as bright as what we would like it to be.”
Bear Stearns’ chief financial officer said the shockwaves hitting lending markets, triggered by rising mortgage losses, were as bad as crises such as the Internet bubble bursting in 2001 or the 1998 collapse of hedge fund Long-Term Capital Management. “These times are pretty significant in the fixed-income market,” CFO Sam Molinaro said on a conference call with analysts. “It’s as been as bad as I’ve seen it in 22 years. The fixed-income market environment we’ve seen in the last eight weeks has been pretty extreme.” (August 2007)
When company executives make these kinds of statements it is imperative that investors closely scrutinize their holdings in relationship to stocks they own that may be levered to the company or sector the executive’s company is in. In my judgment statements such as these should be considered red flags hailing you to prepare to sell. In the case of the home builder it would be any company related to home building, and mortgage companies in relationship to the comments from the Bear Stearns executive. Better yet, by reviewing the stocks in your portfolio on a recurring basis, you should have picked up clues to these impending crises long before these comments were made.
When to sell? Looking at where markets have been in the past can provide you with an indicator of when to sell. You might use the NASDAQ Composite Index as a gauge on when to purchase stocks and when to sell. One approach is to buy stock at 10% declines in the composite, and to sell stocks when the composite gains 25%, these percentage loss and gains are based on the long term historical average of the index.
Another approach is to sell when everyone else is buying. When a stocks notoriety is increasing you might prefer to sell 50% of the holding in that stock, even if you consider it a long term investment you can maintain your base position and add to it again as the price falls at a later date.
There are many approaches to selling stock, the key is to identify your approach, follow the stocks in your portfolio and it’s competitors on a regular basis (at least quarterly), watch for market trends within your stocks sectors, and overall market sentiment. One particular note of caution: If your stocks dividend is cut or if a stocks analyst, creditor, or management team infer that it’s dividend may not be safe, it may be a sign of fundamental weakness in the companies future prospects.
(1)Toll Cancellations Drop; Horton Says Market to `Suck’
Brian Louis and Sharon L. Crenson
Bloomberg, 2007-03-07 15:54