The company you own stock in might not have released bad news, but there are times when the shares may sell off simply because a competitor's stock has taken a beating. This is referred to as the "sympathy effect".
This article will discuss whether investors should take advantage of the sell-off and buy more shares, or sell.
When To Buy
An investor should consider buying more shares of a stock when it meets one of the following criteria:
- The news of the sell-off is specific to another company, not your own.
If the other company is experiencing a problem with a vendor, product, or is having trouble filling certain orders, it might present a big opportunity for the company you own going forward.
For example, at certain points in time Hasbro Inc. (NYSE:HAS) and Mattel Inc. (NYSE:MAT) have traded in sympathy with one another. When one stock moved up, the other one generally followed suit. The same was true on the downside. However, during the 1998 Christmas season, Mattel's stock dropped roughly 17% on worries over its weak product pipeline. Hasbro wisely took advantage of Mattel's weakness and rushed its Furby doll to market. The stock soared from $17 to just over $22 on strong sales of the new doll. Savvy investors that were able to pick up on the fact that Mattel's woes wouldn't impact Hasbro made a lot of money.
Another example is the Boeing Co. (NYSE:BA) and Airbus relationship. In 2006, Boeing managed to garner a number of high-profile, multibillion dollar commercial airplane orders because of Airbus' aircraft production problems and a number of other company-specific issues. As a result, Boeing's stock soared, while Airbus stock declined. (For related reading, see Great Expectations: Forecasting Sales Growth.)
- The company you own isn't subject to the same conditions as the company in its sector or industry that inspired the sell-off.
For example, in 2006, DaimlerChrysler (NYSE:DAI) stock fared well compared to Ford Motor Co. (NYSE:F) or General Motors Corp. (NYSE:GM). DaimlerChrysler had exposure to the U.S. market through Chrysler, but a large percentage of its business was overseas, so it wasn't as susceptible to domestic conditions as Ford or GM. Also, its Mercedes line catered to a high-end clientèle and it didn't have the union related problems that the other two did. Its ability to avoid the problems that had plagued other players is what set it apart.
- It may make sense to buy additional shares even if the industry in which the company operates is tanking.
The company that you own may overcome industry concerns. For example, if a number of companies within the same industry were having problems with a particular vendor but the company you own has plans to switch to a newer, better vendor, it makes perfect sense to buy the stock.
- The company is hedged.
For example, as the price of crude oil increases, transportation stocks generally take a hit. If the company you own is hedged against rising fuel prices, an emotional sell-off across all transportation stocks may present a buying opportunity. Information regarding commodity related hedging activities can usually be found in the company's 10-Q or 10-K, in the Management Discussion and Analysis (MD&A) section. (For more insight, see Commodities: The Portfolio Hedge.)
- Take advantage of a valuation gap.
For example, a big name company that trades at a lofty price-to-earnings multiple may sell off and drag down smaller players within the same industry. After the sell-off, the smaller players trade at such low levels that they become an attractive buy.
During the late 1990s, casinos took a hit on concerns that an economic slowdown was around the corner. Big operators saw their stocks decline, but smaller players took the brunt of the worry, declining by 20% or more. A number of value oriented funds realized that the economy wasn't going to tank after all. They invested in smaller companies such as Casino Magic and Isle of Capri Casinos (Nasdaq:ISLE). As a result, the smaller, cheaper companies saw amazing growth in their share prices for a period of several years while the larger cap players generally languished in comparison. (To learn more about value investing, see Stock-Picking Strategies: Value Investing.)
- There may be a catalyst on the horizon.
A good example of what a catalyst can do is B E Aerospace Inc. (Nasdaq:BEAV), which makes airplane equipment, such as cabin interior products. The company saw its stock decline in a similar fashion to other transportation stocks when oil prices rose. However, savvy investors understood that the long-term demand for air travel remained reasonably strong and regardless of rising oil prices, airlines need to consistently refurbish their aircraft. In fact, the stock soared as the company landed a number of sizable orders.
When to Sell
An investor should consider selling when a stock meets one of the following criteria:
- Macroeconomic concerns are to have a lasting effect on both the company and the industry in which you are invested.
If interest rates rise dramatically and you own stock in a bank or other lending institution, it makes sense to sell. Or, if you own shares in a company in the fast food industry and Congress passes an unexpected increase in the minimum wage, it may also make sense to sell. (For more insight, read Macroeconomic Analysis.)
- Industry-wide supply problems.
As mentioned above industry-wide supply problems can create an opportunity if the company in which you own stock is able to find an alternative supplier. However, if raw materials or certain components only come from a certain region of the world and that region is experiencing difficulties, it may make sense to sell.
This is what happened in the semiconductor industry over the past decade. When North Korea test launched a missile that went over Japan in 1998, chip stocks took a temporary hit on concerns that component makers might be unable to make shipments. The same thing happened when Taiwan experienced an earthquake in 2006 and in the past when tensions between China and Taiwan flared up.
- Industry consolidation makes the company you own less competitive.
Between 2000 and 2001, a number of high-profile drug companies joined forces. Merck & Co Inc.(NYSE:MRK) refused to take part in the consolidation. As a result, Merck's drug pipeline languished and companies such as Pfizer Inc.(NYSE:PFE), received all of the analyst and investment community's attention because their pipelines were filled with potential blockbuster products.
- Excess government regulation and taxation.
For example, if a state bans smoking in its casinos, it could have an adverse impact on foot traffic, which is what has happened in New Jersey when it imposed a smoking ban in 2007.
Carefully study any company you own as well as other major industry players after a sell-off. Often you'll be able to pick up clues as to whether to buy more shares, or to liquidate your position entirely.