If a pair of sneakers from your favorite brand was marked down by 20%, you probably wouldn’t hesitate to add them to your cart. But what about that same markdown in the price of that company’s stock?
That’s what potential investors in Nike stock have been asking themselves of late.
Last month, the athletic apparel manufacturer announced worse-than-expected, declining quarterly sales to cap off a rough fiscal year, and the market reacted swiftly. Nike shares plunged by nearly 20% in the day following the earning results, the worst trading day in the company’s history.
All in all, the stock has surrendered more than 31% year to date.
If there was a similar decline in a broad stock market index, such as the S&P 500, just about every financial advisor on Earth would tell you to stick to your plan and keep investing in a broadly diversified portfolio. Because stocks have historically trended upward, downdrafts are largely seen as opportunities to buy into the market when it’s on proverbial sale.
When it comes to individual companies, though, the choice becomes much murkier. After all, a stock could take major losses and then soar to new heights à la Apple. Or you could buy a falling stock that becomes the next Blockbuster.
“Buying because the stock price has gone down without knowing some of the underlying issues or without understanding some of the underlying activities, could be problematic,” says Clark Bellin, president and chief investment officer at Bellwether Wealth.
“Something can be on sale for a reason.”
How to approach a beaten-down stock
Remember, you should never be making wholesale changes to your portfolio to try to capitalize on any one investment. But if you have a well-diversified portfolio with a sleeve of individual equities, a stock that has fallen precipitously may be an attractive add. You’ll just have to figure some things out before you buy, says Sam Stovall, chief investment strategist at CFRA.
“Any time you have a big selloff in a stock, the question is, will there be more declines in the near future, or is it an overreaction that represents a very attractive buying opportunity?”
Investment pros recommend these three steps to help sort things out.
1. Have a process in place
There thousands of stocks to choose from, and investigating ones that make financial headlines isn’t a great way to narrow things down, says Bellin. “The tendency for a lot of people is to see the dip, then try to do the research to see if it’s something they want to add,” he says. “That’s sort of doing it backwards – and that’s going to cause some problems.”
Rather than scrambling to do research, he says, keep a watchlist of stocks you’d be interested in buying at the right price. That way, you have already done your homework by the time the price slips. You merely need to make sure your thesis on the stock is still intact before pulling the trigger. “If some thing on your target list goes on sale, yeah, go ahead and add a little more to your position,” Bellin says. “Just make sure you’re not overweighting your position. You want to have a fairly well diversified portfolio.”
2. Check the numbers
A stock can hit the skids for a variety of reasons. Maybe the company fired its CEO. Maybe it sunk money into a new product line that the public didn’t like. Maybe investors have soured on a whole sector, and a company has been dragged down alongside its peers.
No matter the reason, it’s important to dig into the company’s underlying fundamentals to see if it’s a stock you want to hold over the long term, says Charles Rotblut, vice president of the American Association of Individual Investors.
“Look at what’s been happening. Look at gross margins and operating cash flows over a period of time,” he says. “See what direction things are headed in. Is this truly a one-time blip? Or has it been a gradual worsening that now appears to be accelerating?”
If the company has major earnings problems, it may be wise to take a wait-and-see approach, says Stovall. “It’s not something that tends to go away very quickly,” he says. “A company has to respond to the issues there, but a lot of times, they won’t do enough the first time around. Sometimes it will take two or three attempts until the issue is fully resolved.”
3. Reassess your outlook
Beyond the numbers, you’ll have to decide if whatever short-term problems that have dragged a stock down represent a meaningful long-term threat to the company’s business.
Ask yourself if investors are overreacting to a problem that’s fixable. It’s not an uncommon occurrence, says Raife Giovinazzo, a portfolio manager at Fuller & Thaler Asset Management, a mutual fund firm that focuses on financial psychology.
“People overreact, in general, to vivid, emotional stories,” he says. “And there’s nothing quite so vivid and emotional as losing money.”
One way to tell if the public is overreacting negatively on a stock is to see if higher-ups at the company are buying – a move that must be publicly disclosed and is available on free sites such as Nasdaq and Yahoo Finance.
“The number one thing we start with is insider buying or share buybacks,” Giovinazzo says. “That’s the event that says, hey, management is not just saying that they think that there’s an overreaction — they’re actually doing something about it. They’re putting their money where their mouth is.”
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