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:

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:

• Seven losing stocks that are ready to turn around.
• Some ugly, risky stocks you should avoid.
• Why things are still going to get worse.