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When Your Stock Chart Looks Like A Lemming's Leap!

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By admiraltroll
October 3, 2003

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Hi Collective,

Many of you are quite comfortable with the fact that stocks that you own can drop by 30% or more. However not everyone is. I posted this over on the Hidden Gems board and thought that some that do not have access there might be interested

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Hi Guys,

There is much discussion on some stocks that have dropped by a good %.

Our immediate psychological reaction is to think "Oh my God I invested in the wrong stock, or I invested in the right stock at the wrong time.

First let me say that you are not alone. EVERY experienced investor posting on this board has had this happen to them with at least one stock. Warren Buffett is quoted as saying that you should not buy stocks if you cannot stomach a 30% drop in stock price.

We can never know the short-term direction of a stock price. Some news may come out that we could not have envisioned. Generally the drop is magnified for small cap (read HG type) stocks as compared to large caps but even these can drop well over 30% sometimes.

So what to do when it happens to a stock that you own?

Well first do not panic! Many a shareholder has been shaken out of an excellent company by fear that they may be holding a loser.

Secondly take your time to assess what is going on with the company. Is this just a temporary setback or is it indicative of a more fundamental flaw in the company? Fortunately here you have TomG and Tom Jacobs + a few other Fools who will help you make that assessment.

My first question is "Are the reasons that I bought this company still intact?

My second question, "Do the assumptions that I made in my valuation still hold good?

If the answer to these to questions is yes then I don't worry.

I often buy what I think is a good company at the upper end of my buy range knowing full well that the stock price might go significantly below my initial purchase price. The truth is I can't tell if it will go up or down but since I'm in it for at least a few years I will welcome the opportunity to buy more at a lower price.

To follow this strategy I'm a great believer in deciding how much I wish to invest in a company and then dividing it into 2 or 3 lots. I invest the first lot and wait. I might get the opportunity to buy lower and if I don't then I may consider buying at higher price or moving on to other equities.

A company that I like a lot is MGIC Investment (MTG), a private mortgage insurer. I valued it at around $70 some time ago. I like a good margin of safety, usually a minimum of 20% and preferably 40% if I can get it. I decided on $50 as my upper buy price and just waited. The stock went up to $68 and eventually went down below $50 and I bought my first tranche at $44+, the stock soon after went as low as $32+, a 27% drop from my purchase. I looked at the company research that I'd done & my valuations and decided that they were still worth at least $65. I bought more at $35.52. Today that stock is hovering around $52 to $56 and I'm still holding and happy with my purchases.

Incidentally I did a full research report on the company and do quarterly conference call (CC) summaries. They are all here in this link.

Sometimes the drop in price is for no other reason than the fact that the market valuation ran ahead of the real value of the company. Other times it is because of a market over reaction to bad news. Remember that the market almost always over reacts on both the upswings and downswings in a company's fortunes. IMO momentum investors give value investors some great opportunities :-)

Our psychological biases are amplified by greed on the upside and fear on the downside. These are normal emotions but we need to recognize when they are affecting our investing behavior.

Of course sometimes a stock drops for a very good reason and perhaps we should be looking to sell it. Here's a brief summary of the signals covered in TMF's "When To Sell" Seminar
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1. An SEC investigation. See news areas of Motley Fool Portfolio, Quotes & Data, SEC Website.
2. The CEO suddenly resigns. Same as above.
3. Enormous insider selling of stock. Yahoo Finance
4. Short Interest surpassing 20%. Same as above.
5. Stock option grants above 3% of total shares (5% for company under 500M in Sales). Same as above, find company "Home Page" and get SEC 10K filings. Find Income Statement; find Average number of Shares - Diluted; record. Find table of number of shares granted. #Shares/ # shares granted = % option grants.
6. Company suddenly changes focus. Emphasis change gross revenue to net margin expansion OR business model.
7. Company focuses on stock price. See conference calls, Wall Street manipulations, etc.; executives paid based on stock price.

Warning Signs:
1. Slowing Sales growth. See #5 above. Use Income Statement to get year-over-year sales for past 4 quarters and three fiscal years.
2. Divergent sales and profit growth. Same as above. Use Income Statement to get year-over-year Net Income Growth. Also see Quotes and Data, MTF Financials.
3. Plummeting cash Flows. Same as #5 above. Get Statement of Cash Flows; record operating cash flow past three fiscal years.
4. Watch those Bonds. Yahoo Bond Center.
5. It just doesn't get any better! Fools Quotes and Date; Snapshot; find Market Cap; see article by Bill Mann on high Market Cap risk.


Gut Checks and Safety Valves
1. Stop Loss: Purchase price multiplied by 0.8
2. 200 DMA: If below look at fundamentals again.

When A Company Becomes Overvalued
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Now of course some of this may be a bit advanced for a new investor and I hope that TMF will run this excellent seminar (Bill Mann, TMFOtter was the instructor) again so I do not wish to go into to much detail but you can get an idea of what to look for on your own. In any case as I said before HG subscribers do get the two Toms looking out for them and will get early notification of any warning signals.

So my main message is stay calm - a fast trigger figure has no place in long or even medium term investing.

Best Regards
Philip


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