When Your Stocks Turn Into Lottery Tickets

Nearly everyone has suffered in this bear market. But the credit crunch has put many investors in a position where they've lost nearly everything on particular stocks. When you've already seen losses of 80%, 90%, or more on a stock, what's the right thing to do?

Anyone who has invested in financials has seen some brutal drops. A quick check on the Motley Fool CAPS screener shows a number of financials sitting on losses of 75% or more in the past year:

Stock

1-Year Price Change

Fannie Mae (NYSE: FNM  )

(90.8%)

MBIA (NYSE: MBI  )

(79.8%)

First Marblehead (NYSE: FMD  )

(85.3%)

Washington Mutual (NYSE: WM  )

(88.8%)

Source: Motley Fool CAPS.

But you'll also find some big hits outside the financial sector as well. Even in the hot energy sector, Western Refining (NYSE: WNR  ) is down 84%, as crack spreads between the cost of crude oil and prices for gasoline have narrowed. Tech consultant BearingPoint (NYSE: BE  ) has fallen to near penny-stock status, and once-popular shoemaker Crocs (Nasdaq: CROX  ) is off more than 90%.

Give up or hold on?
After sticking with a stock through a sharp decline, your first impulse may be that there's no reason to cash out so late in the game. Since you didn't decide to sell when your shares had dropped 25% or 50% of their value, why would you settle for pennies on the dollar? Instead, you might want to treat your beaten-down shares as lottery tickets on a recovery -- no matter how long the odds might be.

Those who advocate holding on can point to numerous examples of stocks that were given up for dead, only to come back from their lows. USG, for example, flirted with liquidation earlier in the decade, but rose from $4 to trade above $100 for a short time. Online bookseller Amazon.com traded in the single digits after the tech bubble burst, but rewarded those who stuck with it by recovering nearly all its losses by late last year. Even Bear Stearns gave shareholders who didn't immediately sell their shares a bonus, as the original $2 buyout offer was soon raised to $10.

Being reasonable
The problem, though, is that many stocks never come back from big drops. If you've stuck with a company through thick and thin, it's tough to look at its stock objectively. But that's exactly what you have to do.

You can usually identify the reasons why a stock suffers a big decline. Those causes often completely transform the underlying business of a company. For example, all the subprime lenders that went out of business last year did so because the market niche they had carved out for themselves simply ceased to exist. Similarly, many of the problems that more mainstream financial companies are working through now are only problems because there's no sign of credit markets returning to business as usual.

Ultimately, whether a stock will bounce back from a huge drop depends on the ability of company managers to adapt to radically changed business conditions. If management successfully finds new ways to be profitable, then the odds of surviving a crisis go up substantially. But if insurmountable obstacles prevent a company from finding a new direction that will work in the new environment, then it's much more likely that the company's stock will eventually end up being worthless.

The best way to evaluate stocks that have suffered big losses is to take a fresh look at them and their prospects. If you conclude that you wouldn't buy new shares at the low price, then it likely makes little sense to gamble on a recovery. But if you can see ways that the company could both survive and thrive again, then holding on a while longer makes sense.

For more on investing in down markets:

First Marblehead is a Motley Fool Inside Value recommendation. If you're interested in picking through the wreckage for possible turnaround candidates, you should have the Inside Value team on your side. Check it out for free with a 30-day trial.

Fool contributor Dan Caplinger doesn't own shares of the companies mentioned in this article. Crocs is a Motley Fool Hidden Gems Pay Dirt pick. Try any of our Foolish newsletters today, free for 30 days. The Fool's disclosure policy will take care of you.


Read/Post Comments (4) | Recommend This Article (6)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On August 20, 2008, at 4:17 PM, birdtard wrote:

    Once again the Fool has no answers - only double talk.

  • Report this Comment On August 20, 2008, at 4:33 PM, Ishortyou wrote:

    Lets assume the worst and that is the Fannie and Freddie stock go bust to zero, the government take the GSE's, so what? are we going to h*** for that? are the mortgages in their books go bust? are we going to crush? the answer is no! all those mortgages in their books will automatically be backed up by the government and even be rated as triple A, that will upgrade the books of all of those holding them into CDOs, MBS, SIVs and cause massive write ups! so what is the nonsense in here? that would be the best case scenario for bond and mortgages insurers, I am sure there are many of them praying for the government to take over the books of Freddie and Fannie.

  • Report this Comment On August 21, 2008, at 8:46 AM, captainccs wrote:

    Just because a stock is down 90 or even 99% is not a reason to sell, not a reason to convert an unrealized loss into a realized loss. The buy/hold/sell decision must always be based on your future expectations for the stock and the company.

    Dan Caplinger has shown how much these four stocks have fallen but he has not shown how much they have bounced back. I had a look at these stocks last night and the results are quite interesting:

    The columns are:

    Ticker, Low date, Low price, Close 8/20, Bounce

    MBI 6/30/08 3.62 10.49 189.8%

    FMD 7/15/08 1.65 3.95 139.4%

    WM 7/14/08 3.03 4.10 35.3%

    FNM 8/20/08 3.95 4.40 11.4%

    http://boards.fool.com/Message.asp?mid=26918170

    While FNM continues to be a falling knife, FMD, for example, has shown signs of life with the Goldman Sachs cash infusion and the return of Dan Meyers. Look at the company story, not only at your profit or loss. The "preservation of capital" is a slim excuse. You should preserve capital while there is capital to preserve, not after you have lost 90% of it.

    Long FNM, FMD

  • Report this Comment On August 21, 2008, at 2:51 PM, TexasLonghorns wrote:

    What was once a "Rule Breaker" has now become a "Inside Value" newsletter pick. I've got better names for the newsletters, but can't use them here. This pick and quite a few of their other ones cost me some bucks. Finally found a real newsletter to subscribe to which has me up 14% in a month. I'm down so much on this one that's all it is a "Lottery Ticket" don't even watch it much. It goes to zero, it goes to zero. Almost there now!

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