If a stock dives, you don't need to panic

Dollars & Sense

April 06, 2003|By David Kathman | David Kathman,MORNINGSTAR.COM

Dear Analyst,

I buy a stock, one that is recommended as a good buy. The next day, I check the market to discover that my stock has "overnight" dropped 20 percent, 30 percent, or more! How and why do the big stockholders get the sudden notion to sell out? Where does the information, which I've been denied, come from?

A. Unfortunately, this scenario has become all too common over the past couple of years, as a string of corporate scandals has rocked an already jittery market and undermined investor confidence.

It's disconcerting, to say the least, when a stock you own takes a dive, and it's not always easy to know what to do. But by keeping a cool head, you can minimize any damage, and maybe even come out ahead in the long run.

First, let's consider the main question: What causes a stock to fall off a cliff and drop 30 percent, or even 10 percent, in a few minutes? Every stock is different, of course, but a few main causes tend to be behind these blowups. One of the most common is that a company announces its earnings for the coming quarter or year will be significantly below Wall Street's expectations.

Similarly, the market tends to punish a stock if a company withdraws its previous earnings guidance, or if it says it will meet expectations for the current quarter but expects a shortfall down the road.

The magnitude of a stock's drop doesn't necessarily correspond to the size of the earnings miss, since so many other factors come into play. For example, on March 20 Intuit (INTU) said sales and earnings for fiscal 2003 would be about 5 percent below expectations, and the stock fell 24 percent because the market feared further slowdowns in sales of Intuit's core TurboTax and QuickBooks software. The same day, State Street (STT) said its first-quarter earnings would be about 15 percent below expectations. But the stock dropped only 12 percent - half as much as Intuit - because the shortfall was mainly because of changes in interest rates and other market-related factors not under State Street's control.

Another common reason for a stock to tank suddenly is accounting issues, especially after Enron and all the scandals that followed. When a company announces it will have to restate its earnings or that it's under investigation by the Securities and Exchange Commission, or suggests in any way that its numbers might not be on the up-and-up, its stock price will fall, sometimes dramatically.

So what should you do if a stock in your portfolio blows up? One thing you shouldn't do is panic. Bad news almost always comes out when the market is closed - either in the evening after the closing bell, or in the morning before the market opens - so there will usually be a lot of "sell" orders for that stock piled up when the opening bell rings. Even if you find out about the news in time, you almost certainly won't be able to sell in time to avoid a loss. In fact, if you join the opening stampede of selling, you might be worse off, since such stocks often bounce back from their initial lows.

Instead, look at what caused the stock to tumble, and whether your reasons for owning it are still intact. If you've got serious doubts about the company's trustworthiness or its long-term profitability, you may well decide to sell.

That could happen in the case of an Enron- or WorldCom-style accounting disaster, for example. On the other hand, if the problems look temporary, it might be a good idea to stick it out, especially if you're investing for the long term. In fact, you may want to consider buying more shares at the new-and-improved price.

In the case of Intuit and State Street, Morningstar's analysts didn't feel any need to change their fair value estimates after the stocks fell because those fair values are based on long-term expectations. Mike Trigg, who covers Intuit, already thought the company's sales projections for TurboTax and QuickBooks had been too aggressive, so the new guidance didn't change his outlook; in fact, the stock fell to a level very near his fair value estimate. Rachel Barnard, who covers State Street, thinks the current issues are short-term and that the stock is still undervalued.

It's impossible to tell just from a stock's behavior whether its problems are short-term or more fundamental, because the market often doesn't do a good job of distinguishing the two. But doing some research can give you a better handle on what went wrong and what you should do about it.

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