Investing: In Times of Trouble…

What a difference a month makes. Last time, the downturn in stocks was just beginning. It’s Thursday, August 15, 2007, and already, the Dow has had its worst week since 2003. Today, the Dow dropped below 13,000 to 12,861 (a little more than a month ago, it touched an all-time high of 14,000), and the S&P has turned negative for the year. I saw a friend today, and he remarked, “My index fund has given up all its gains for the year!”


In the last few weeks, it seems as if a day hasn’t passed without some major revelation that has sent the market sliding. Last week it was a European fund in trouble, followed by a Goldman Sachs’ quantitative fund; this week, concerns around Sentinel Management, Thornburg Mortgage, and Countrywide Financial all triggered major drops in the Dow. And no one knows the answer to the big question: when will it end?

Chances are, if you own some stocks, many of them are down. And chances are, some of them are below the price you bought them at. Meaning, you’re looking at possible losses in your portfolio.

So in the midst of this turmoil, what should you do? If you watch the stock shows, or read the usual literature, everyone seems to say, “Sell! Take the loss!” Investor’s Business Daily advises you to sell if a stock drops more than 8%, arguing that statistically, stocks are unlikely to come back if they fall that much. Jim Cramer, of Mad Money, is telling everyone to sell financials and mortgage-related stocks, especially on any rise in the stock price. Another CNBC pundit advises, “Sell until you can sleep.”

Buy and Hold… but only if…

In the midst of all the chaos, no one seems to be talking about buying and holding. In fact, that talk almost seems to be verboten (forbidden, in German). If anything, the popular paradigm these days seems to be buy high, sell higher. Turn on the TV, and it seems to be all you hear, especially on CNBC.

But here’s a thought: what’s the best investor of our time, Warren Buffet, doing? I definitely can’t claim to know for sure, but it’s very likely he’s not selling. More than likely, he’s going old style, doing the buy and hold.

But here’s the caveat: Buffet can do it because he picked a good company in the first place. Meaning, he picked a company that can weather bad times. And on top of that, he probably bought it at enough of a discount that regardless of any short or medium term dips, he’s still going to do fine in the long term.

So here’s my point. If you think a serious downtrend is coming, definitely sell ahead of the decline if possible. If you are late and have to face the possibility of taking a significant loss, consider holding if a) you have purchased a company strong enough to weather bad times; and b) if you’ve bought at a price that gives you a reasonable expectation of recovery within the next few years. If you seriously believe that the stock cannot return to the price at which you bought it, then it may be time to sell and cut your losses.

Spotting the Sell: Watching Goldman Sachs’ 50, 100 and 200 Day Moving Averages

Saying these things only raises more questions, the first of which is, “How do I know when to sell?” And “When should I hold?” Let’s deal with the first one now.

There are lots of potential sell indicators. In a previous article, entitled “Buying the Cycle”, I suggested looking for a catalyst that will spur growth. It follows that if that catalyst disappears, or ceases to drive an industry, then it’s time to get out.

But this is an imperfect and rough tool. Limiting yourself only to this indicator can make it hard to time an exit, because markets often move in anticipation of possible problems. Also, staying narrowly focused on specific indicators can leave you open to being blindsided by other issues… such as the subprime slime.

So let me give you another simple, and very useful indicator that I look at: the 50, 100 and 200 day moving average. Simply put, these are averages of the stock’s prices over the last 50, 100 or 200 days. You’ll find that in rising markets, the stock price stays ahead of these indicators. You’ll also find that in declining markets, the stock will fall below these indicators. Also, know that there are two versions: the simple moving average, and the exponential moving average. I tend to use the exponential, because it weights recent events more heavily.

My rule of thumb is, if a stock falls below the 50-day, you should watch carefully. If the stock falls below the 100-day moving average, you should consider it a possible sell signal. And if the stock falls below the 200-day moving average, you should strongly consider selling.

Let’s take a look at an example, Goldman Sachs, the example we used last time. By the way, the great thing about living in this age is that the information is readily available. Go to almost any stock website, and you’ll be able to plot these averages on a chart, and all for free. So let’s take a look at the chart for Goldman Sachs:

Goldman Sachs chart

The red is the 50-day average, the green is the 100-day, and the orange is the 200-day moving average (all exponential moving averages, in this case). You’ll see that during the stock’s upward run from September, 2006 to March, 2007, the stock stayed well ahead of the 50-day moving average. In March and in late June, 2007, the stock tumbled and crossed both the 50-day and the 100-day averages. In both cases, the stock did not fall below the 200-day moving averages, and fought back. But in July, support for the stock collapsed, and on July 23, 2007, Goldman fell below it’s 200-day moving average of about $205. It’s been downhill ever since.

Pretty useful, don’t you think? Still, keep in mind, this is a tool – “ a category_ide rather than a rule. It’s important to try to take into account all the possible relevant factors. As mentioned in my last article, I sold my entire Goldman Sachs position in the $207-208 range. In this case, the market negativity, the spreading subprime issues, rising interest rates, and the stock’s already huge run all contributed to my sell decision. Now I managed to sell Goldman before it crossed its 200-day moving average, but had I not done that, the cross at $205 would have given me a major red flag.

Hold or Sell? – Boeing and Altria

We’ve talked about a sell situation, so let’s look at the other side, when to hold. I’m holding on to two stocks we’ve mentioned in this series, Boeing and Altria. Why?

Before I get to that, you should know that both have fallen in recent weeks. About three weeks ago, on July 25th, Boeing reached an all time high of $107.23. Today, it’s at $95.51, and is approaching its 200-day exponential moving average of $93.0178.

Likewise, Altria (comprised of Philip Morris domestic and international, and maker of Marlboro cigarettes) was trading between $68 and $72 since the Kraft spinoff back in late March. Today, it closed at $65.98. In my last article, I said that Altria was a buy in the $68 range.

Now both Boeing and Altria are not directly linked to the “subprime slime”. Meaning that subprime-related securities do not have a direct effect on their income statements. Boeing is still driven by the airplane replacement cycle. While a credit crunch could slow purchases, Boeing has a multi-year backlog, and interest rates are still low by historical standards (buyers have bought planes at much higher interest rates in the past). Altria’s profits are driven by smokers, who seem to buy cigarettes even when they’re making less money.

So why have both stocks dropped? Not because these businesses have deteriorated, but because holders of Boeing and Altria stock needed to liquidate to get cash. When the subprime problems hit, investors demanded that hedge funds and other investment companies return their money. Many of these funds held subprime-related securities that couldn’t be sold. So, they sold their more liquid stock assets instead – “ namely, stocks like Boeing and Altria.

So that’s why I’m holding – “ I think they are solid companies, and there is nothing fundamentally wrong with their businesses or the demand that drives their businesses.

Buy and Hold Case Study: Nokia

Even if there is a major problem with the business, buy and hold can still be an effective approach. But remember the caveats – “ if you invested in a strong company, and if you bought at a price that the stock could return to (worst case) or even better, exceed sometime in the next few years.

Back in January, 2004, I had dinner with two former colleagues. One of them had become an analyst at a major research firm. He had done a great job calling the tech bust back in 2001, and was recommending Nokia.

Nokia was the leading cellphone maker, with about 40% market share. It had fallen from a high of $58.25 in June, 2000, to as low as $11.18 in July, 2002. By January, 2004, the stock was in trading in the low $20s, and the company, having come out with new products that targeted affluent customers, seemed poised for a recovery from its 2002 lows. So I, along with the third colleague at dinner, bought some Nokia stock. I purchased on January 29, 2004, at $20.60.

Nokia chart

As you can see by the chart, that turned out to be a major miscalculation. After climbing to $23, Nokia missed earnings targets. It turned out that Nokia had been so focused on the upscale customer that it had lost significant market share to lower priced competitors. Specifically, it had completely missed out on the trend toward clamshell style handsets. Within weeks, the stock dropped to the low teens, and by mid-August, it was back in the $11 range.

My dinner colleague, who had also bought stock, sold at a loss. Now I didn’t like the idea of doing that, and truth was, I didn’t really need the money right a way. So there was no reason I couldn’t just hold on to the stock and wait for a recovery. Now if I thought that the stock was going to zero, then it was better to sell and save what I could. But I didn’t think that was the case. So I held.

Keep in mind, this is a major advantage that individuals, or private investors like Warren Buffet, have. Most fund managers must show profits every quarter, or at least every year. So if they don’t think anything is going to happen with their stock in that time period, the incentive is for them to get out, sell at a loss, and re-deploy whatever they can save. Individuals or private investors don’t have to do that; they can hold. Unless they need the cash, or unless they think they can make up the loss elsewhere, individuals can hold and wait.

Nokia fought back, producing updated models for all price ranges. With Motorola stumbling, Nokia began to rebuild market share. Today, Nokia closed at $28.85, a 40% gain over my acquisition cost of $20.60 three and a half years ago. A couple weeks ago, Nokia reached a multi-year high of $30.90, which was 50% above my buy. And remember, this is all after having dropped to $11 a share. In fact, if I had bought more stock below my $20.60 acquisition cost, I would have reduced my cost basis and increased my return.

So buy and hold can work, depending on the situation. Sometimes the right answer is to sell, but in many instances, people sell too early, or sell just because a stock is down. But if you have a stock that can weather bad times, and you bought at a reasonable price, then it’s worth considering holding through the rough patches.

Thanks for reading, and until the next time, sleep well.

Ming Lo is an actor, director and investor. He has an A.B. from Harvard College, Cum Laude, and an MBA and an MA Political Science from Stanford University. Prior to going into entertainment, Ming worked at Goldman, Sachs & Co. in New York and at McKinsey & Co. in Los Angeles.