4 Steps to Know When to Fish or Cut Bait on a Stock
We call it “handholding.”
It’s one of the tools in every investment writer’s kit.
Despite the condescending-sounding name, handholding is a critical part of the job description of every one of us here at Banyan Hill.
Handholding isn’t about covering your behind when you make a bad recommendation.
It’s an essential part of what you pay us for. It’s the ongoing analysis of our previous recommendations.
It’s not enough just to brag about gains we’ve made.
We also have an obligation to explain why certain recommendations have gone down … where they’re likely to go next … and what you should do with them.
Sometimes, a bad bet turns out to be just that.
Lipstick on that pig won’t help.
When I take a flier on a promising startup that turns out to have lied to investors to manipulate its stock price, I swallow my pride, admit my mistake and move on.
That’s the easiest version of handholding.
Much more difficult is explaining why you should stay smart and tough and stick with a position even when it’s down by serious double digits.
It’s a hard job.
All of us — investment writers included — have a strong aversion to loss. It’s hardwired in us humans.
To combat that emotional tendency, we must rely on our powers of reason.
But when I use reason to explain a particular stock decline, it can feel like special pleading.
Every specific case of a newish company that’s declined in value shortly after its launch is just a variation on a broader theme.
History shows that not only do these things happen … they often don’t last.
Investors who understand that broader tendency go on to the big gains.
So today, let’s talk about their broader tendency … how do we know when to hold ‘em and when to fold ‘em?
There was once a startup company whose chart looked like this:
Within two years of going public, the company’s stock appreciated by 5,600%.
Then it tumbled by nearly 90%.
Plenty of investors bailed then. They convinced themselves it was overhyped. They kicked themselves for drinking the Kool-Aid. The so-called revolutionary technology had no future.
Today, $1,000 invested in that company at its rock-bottom low is worth … over $58 million.
The company was Amazon (Nasdaq: AMZN).
It’s a common scenario in stock market history:
- A disruptive sector … like e-commerce … generates buzz and FOMO (fear of missing out). Investors pile in, driving up prices of every startup they can find, regardless of quality.
- Soon, people get nervous. They know the stocks are overvalued relative to their current earnings, which are often negative.
- Eventually, the human fear of loss that beats in the heart of every investor becomes a mousetrap. An accumulation of little doubts inches the finger closer and closer to the “sell” button.
- Eventually, some external trigger causes a broad sell-off. For the most overvalued stocks, it becomes a cascade … like Amazon’s 90% drop from its April 1999 high. Snap!
- But a few companies survive. They grind out the hard work of constructing a new economic sector where nothing existed before. Investors who stayed smart and tough become millionaires.
But staying smart and tough isn’t easy.
Consider Amazon’s chart after that catastrophic decline in the late 1990s:
AMZN stock didn’t regain its early baby-fat price level for another decade. After recovering quickly in the early 2000s, it traded sideways for years.
The rest, as they say, is history.
The question is … which version of Yowza! do you want to experience?
No Gain Without Pain
That was a trick question. Any early investor in Amazon experienced both “yowzas.”
The first was exhilarating. The second was soul-crushing.
And because the second involved loss, the natural human tendency was to abandon the stock, and not to return until it had proven itself more than a decade later … perhaps never to return at all.
But some investors got to experience the third yowza — the $58 million one.
Not every company is an Amazon.
But many companies can deliver Amazon-like returns if you stick with them. You don’t have to be big to make big gains.
The question is how to know which is which.
Using Logic to Fight Emotion
Here are some steps to go through when deciding whether to fish or cut bait when you’re down deeply on a new company:
- Is the broader bull thesis for the company’s sector intact? Does the sector have future based on the overall direction of technology? Are we talking Polaroids or smartphones? Blockbuster or Netflix? If the company in question is on the right side of history, move to the next step.
- Where does the company sit in that sector? Is it on the leading edge, or is it a second-tier wannabe? Is it increasing sales volumes and revenues over time? Or is it losing market share? If the company is a sector leader, go to the next step.
- Are there any specific threats to the company? Things like stealing somebody else’s technology or its products causing harm to consumers? Are they survivable? If there aren’t any issues or they are transitory, go to the next step.
- Can you afford to wait to see what happens? Or do you need to get a quick return on your money? (Of course, if you couldn’t afford the risk of investing in a startup, you shouldn’t have bought it. And you shouldn’t have invested more than a small percentage of your overall portfolio in any case.)
If the answer to the last question is yes … then you know what to do!