Stand Firm When Your Shares Take a Hit

Stand Firm When Your Shares Take a Hit
Monday July 7, 1:00 pm ET
ByArne Alsin, RealMoney.com Contributor

This is Part 1 of a two-part article.

Get inside the mind of the average investor, and you're in for wild and crazy ride. Metaphors like "the glass is half-full" or "the glass is half-empty" don't apply -- they're too tame. When the glass is brimming to overflowing, investors see it as empty. And when the glass is empty, investors cradle it with care so they don't spill the contents.

The up-is-down, down-is-up mind-set of the typical investor is evident in this example: An investor figures that Whirlpool is worth $120 per share. (Note: My calculations indicate a higher value.) The investor pays $90 per share for the stock and happily imagines taking a $30 profit when the price eventually migrates to fair value. Then the investor watches the stock quote fall from $90 to $80 to $70, and then to $60. The price drop is proof, to this investor, that he made a mistake. So he sells the stock. It's a dumb move. If there is no long-term impairment to Whirlpool's value, it's dumb to sell the stock just because the price quote has dropped.

Investors make dumb moves in the stock market with regularity. It's not because of a lack of intelligence, a lack of effort or a lack of attention. The proximate cause of dumb moves is a lack of understanding. You can't play a game of strategy if you don't understand the game.

Here is a foundational formula for investing in the stock market. Investors suffer significant capital destruction when they act in contravention to this rule. Memorize it. Imprint it into your memory. It might prevent you from making a dumb move in the market.

Here's the short version: Absent a material change to the business, as price declines, risk declines, and your anticipated rate of return increases.

Here's the longer version, applied to the Whirlpool example above: Absent a material change to the business (there has been no impairment to Whirlpool's value), as price declines (the price drops from $90 to $60), risk declines (risk declines because the gap between price and value increases), and your anticipated rate of return increases (selling Whirlpool is dumb, because your capital increases 100% if you hold the stock from a $60 quote until you can get full value, or $120).


To understand the formula better, let's take it apart, piece by piece:

The Qualifier
Absent a material change to the business...

When there is a material change to the business, sufficient to impair the underlying value, the formula does not apply. Here are a few examples of a material change: a permanent loss of market share, product obsolescence and a reduction of profit expectations over the long term.

The current imbroglio surrounding financial companies is a material change, and it requires a valuation adjustment. For example, owners of Citigroup , Lehman Brothers and Washington Mutual , among many others, have suffered equity dilution while, at the same, time, billions of dollars of assets have disappeared from their balance sheets.

What about the recession? Does a recession constitute a material change, sufficient to warrant a diminished business valuation? The answer is, generally, no. A cyclical pullback in the economy does not affect the long-term value of most businesses. That's because smart analysts already factor cyclical pullbacks into their valuation analysis.

The fact that Whirlpool is struggling with a cyclical decline in demand is no big surprise. Not only is the current cycle not a surprise, but skilled analysts will build at least one more difficult cycle into their model for the next 10 years.
Price

As price declines...

If your neighbor offers you one-half of the value for your car, you'll probably laugh it off.

If a stranger parades into your family-owned business and offers you one-half of value, you might roll your eyes or shake your head. You might even be offended. That's because you see these offers for what they are: nonsense.

When it comes to stock quotes, though, otherwise rational, sentient beings take on a wild and crazy mind-set. If you are like most investors, after you pay $90 for Whirlpool stock, the stock quote suddenly carries great meaning for you. It can make your day or it can ruin your day. Even if you don't sell the stock when the price drops, you'll tell your spouse: "We've lost one-third of our money on Whirlpool."

Here's the reality: There is no difference between your neighbor's offer for your car, the stranger's offer for your family-owned business and Whirlpool's stock quote. Each is an offer for your property. Each is an offer you don't have to accept. The offers are not based on a careful appraisal of value. They're just offers.

After your neighbor's offer, you aren't going to say, "I lost one-half of my car value today." And after you hear the stranger's offer, you won't announce: "One-half of our family business value disappeared today."

Do you know why you will not say these things? Because they are not true. It would be a dumb to accept a one-half of value offer for your car and for your family business. A lousy offer is a lousy offer.

And that's all it is.

Look for part two of this column next week, when I'll complete the discussion of the rule above.