How to handle an underperforming stock
Every company hits a rough patch at some point, but it’s up to you to determine whether a stock price decline is temporary or something more serious.
Updated 
5 min. read
Maybe the company crossed an ethical line, or the CEO resigned unexpectedly. Or maybe a world-wide pandemic has created market volatility. Either way, that blue-chip stock you thought was part of your portfolio’s foundation is now falling and it’s up to you to figure out how to repair the damage. Now, more than ever, investors are faced with the decision to sell off their underperforming stocks or weather the storm and wait it out until COVID-19 passes.
So, what should you do?
Before deciding when to sell an underperforming stock – if that’s what you want to do –remember that impulse selling is often a big mistake. Many stocks have seen their share price fall in value because of a missed quarterly report, a departing CEO or another reason only to see it rebound to even greater heights. Today, many are now feeling the impact of COVID-19.
Of course, it’s not always easy for people to stay patient – and there are many examples of companies that have run into problems, only to go bankrupt. But, before selling an underperforming stock, do your due diligence to ensure that the reason you bought the company in the first place still makes sense.
Here’s what to look for when determining whether your beloved stock will rise again.
See if the company’s story still makes sense
Fabrice Taylor, the Toronto-based publisher of the President’s Club Investment Letter and long-time market analyst, says these are the moments that separate true investors from mere speculators.
“A real investor has to think — they can’t just blindly buy stocks and sell stocks,” he says. “Most people have the intellectual wherewithal to figure things out. Just read as much as you can and, using your own intuition and logic, ask yourself: how bad is this? And how bad could it get?”
That’s a question that’s often more easily and effectively answered with qualitative data than with numbers and charts. One key question to ask yourself is whether the damage is temporary or permanent. “Is the earnings power of the company permanently impaired, or will it come back?” asks Taylor. Maybe the company is forced to sell off a particular division – will that help it focus on its core operations or is the business falling apart? Maybe a new competitor is pressuring margins and it hasn’t been able to capture the market share it once had. Ultimately, think about why you bought the company in the first place see if your investing thesis still stands. Do you believe the company is well-suited to weather the COVID-19 storm and bounce back from it? If so, it might be worth holding onto its stock.
Determine the source of the problem
Another question worth asking: did your stock take a hit because of something the company did, or something that happened to it and its sector peers? Is it the result of, say, a fumbling founder who doesn’t want to relinquish control of the company, or a downgrade of the entire industry? If it’s the former, Taylor says, that can often be recoverable. If it’s the latter? You may want to head for the exits, especially if the decline isn’t due to a cyclical downturn, where profits can rise or fall based on a buying cycle.
“If it’s a trend then it’s not going away,” he says. “That damage could be permanent.”
Be cautious about buying underperforming stocks
If you’ve assessed the damage and determined that it’s cosmetic rather than crippling, you might be tempted to average down – that is, buy more shares at a lower price, reducing your average purchase cost. Taylor says you should resist that urge.
“When you’ve got serious damage to a business, it takes a while for investors to digest it,” he says. “Stocks that start to go down have momentum – they tend to keep going down.”
Pay attention to earnings
Instead, hang on to your cash and watch key metrics like the company’s core earnings and its dividend payout ratio. If it continues expanding its earnings – share price can falter even if it’s continuing to grow – and if it’s still able to cover its dividend payments then it should be able to get back on track, along with its share price. (A dividend cut almost always causes a company’s share price to drop as investors don’t like losing out on their payments.) If the fundamentals continue to look good, then consider buying in.
Don’t put too much in one stock
Going forward, make sure you size your positions properly so that no one stock can sink the entire portfolio. Generally speaking, you don’t want to have more than 5% of your portfolio in any one name; and even that may be too much. If you’re willing to do the legwork, you might want to consider putting trailing stops – an order to sell any stock that drops below a set price – on your holdings and moving them up or down as necessary. Think of it as insurance in case one of your stocks tanks.
Above all, though, don’t panic – and don’t guess. “If you’re (guessing), stay away,” Taylor says. “Because you’re probably going to be wrong.”
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Quotes in this article have been obtained through phone interviews.
The information contained herein is not, and should not be construed as, investment, tax or legal advice to any party. Investments should be evaluated relative to the individual’s investment objectives and professional advice should be obtained with respect to any circumstance.
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