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Breaking free from toxic investments - Part 2

Updated 19 Oct 2018 – By Contributor - Focus Malaysia

Last week, we took a look at what some of the common signs are that one should look out for when it comes to cutting one’s losses in the world of investing. We then took a look at a real-life example of someone who cut his losses on time and saved himself from sure financial ruin. In this final part, we take a look at one more common sign which you should be aware of, including advice from industry experts on how you can make the whole process a little less painful!

Check the fundamentals

Unit trust investors, who are buying collective investment schemes rather than individual company shares, make their investment decisions based on the fund’s geographical region or asset class. On this asset class/region investment decision, investors ought to look at the fundamentals of investing and assess the principal points for the equity market, says Fundsupermart Malaysia’s general manager Wong Weiyi.

“These fundamentals include assessment on the economy, of which fiscal and monetary policies are of great importance. We look at the earnings growth of the companies, the dividends level paid by the companies as well as the price-to-earnings ratio of the companies on the index level (such as S&P 500 for US and Nikkei 225 for Japan) among others,” explained Wong.

The markets' movements are usually leading economic indicators. As such, when markets start to plunge by 10% in a month, for example, investors need to reassess the fundamentals because an impending recession will reduce the earnings growth of companies, which could impact the attractiveness of the markets.

“So in short, we look at fundamentals; if there is no change in the fundamentals, we wait for a rebound patiently. However, when fundamentals change in terms of worse than expected economic growth, or lacklustre earnings growth, then we have to cut losses,” said Wong.

Pauline Yong, author of I Love Stocks concurs that fundamentals play a key consideration in determining whether one should part with one’s investment. In fact, when deciding whether to cut losses on a stock, she always asks herself the following two questions:

1) Is there a fundamental change in the company?
2) Are the technical indicators pointing to the exit?

From the fundamentals perspective, the financial ratios that offer hints of a troubled company are historical and hindsight bias, noted Yong. In other words, by the time financial figures are released, the prices may have dropped significantly.

It is for this reason that Yong would rather look at the market share or market share-related statistics instead.“If the company has been showing a declining market share, chances are the company may produce subpar returns later. Hence, a smart investor would take the necessary steps ahead of others, instead of waiting for the audited annual financial report,” she explained.

Sometimes, official market share statistics can be found in press releases, for example the Malaysian Automotive Association for the car industry, or from analyst reports. “Unofficial statistics are actually from our own observations, such as when we see Celcom having aggressive promotions, and friends are switching to them. We can thus have a rough idea that perhaps Axiata is gaining market share,” clarified Yong.

For industries without readily available statistics, Yong looks at their gross margin rather than competition to gauge how lucrative the business really is. Whether a company can withstand unfavourable challenging environments depends on its gross margin to cushion the negative environment, she explained.

Fundamentals aside, Yong also relies on the technical chart of a stock for a more complete answer. “Technically, when a stock falls more than 20%, it is an indication that the stock is probably in a bearish market territory, which means the stock may not recover for at least six months and beyond,” said Yong, who advises those without holding power to cut losses at this point.

“However, if the stock is fundamentally sound with a large market share in the industry, the temporary setback maybe due to macro-economic factors, and given time, the stock should recover together with the general economy,” she elaborated.

Yong also refers to the 200-day moving average, which indicates whether a stock is worth holding for long term: “This line is an average of the past 200-day prices, which gives you an idea of the general trend of the stock price. If you see that your stock price is above the line, it indicates that it is still worth holding for long term. However, once you see that the stock price has crossed below this line, it means you need to cut loss even if you are a long-term investor.”

The other indicator that Yong relies on is the double top chart pattern, which she describes as “a classic chart pattern that every investor should learn to save you from grave mistakes”.

It describes a scenario when prices went from low to high to form a first rally, then when hit by some bad news, the stock price fell to form a trough. Investors eventually shored up the price of the stock again when it fell too low, leading to the formation of the second rally.

“During the second rally, investors realised the situation did not improve and they started to sell down the stock again. This round, the stock fell below the previous trough and investors panicked and the selling intensified, as the so called “neck-line” of the double top was violated,” she explained.

This pattern has to be significant enough for this chart pattern to be reliable, Yong cautions. “To be significant, the chart pattern is formed through a series of price actions that last for weeks, months or sometimes years,” Yong further elaborated.

“For example, comparing a double top chart pattern formed during a period of nine months, and a small double top chart pattern that was formed within three or four weeks, the smaller chart pattern is less significant or poses less ‘threat’ to a long-term investor, as the price fall may last for weeks only,” Yong added. However, she cautions when a large double top chart pattern’s neckline is violated, as chances are that the stock is entering into a long-term bear market.

Making the whole process less painful

It can be nerve-wracking when deciding whether or not to give up on an investment where the value is sliding or stagnant. Like most investors in your shoes, you’re not sure if you’re making the right move.

In this case, staggering the process of cutting loss could be one of your strategies. Making a decision to cut losses and invest actually subjects the investor to the same price risks, according to Wong.

“In investing, we always advise investors about dollar cost averaging (DCA), meaning that if they have a huge sum to invest in the market, they can break that sum into smaller investment amounts and deploy those monies over a period of time, instead of purchasing the investment in one shot.

“This DCA strategy is useful especially when markets are very volatile, and you have little confidence that markets will rise in the short term. Of course, if an investor is confident of his research and is willing to hold long-term, he could still invest one lump sum,” explained Wong.

He believes that this strategy is applicable to investors who are looking to cut loss. Again, whether you should dispose partially or in full depends on how confident you are of your research. If you are confident that fundamentals of the invested market have changed, or the selected fund manager has lost his touch, go for a clean cut. “However, if one has invested a huge sum and wants to cut loss or change strategy, he could also liquidate his position by parts,” Wong added. 

Be that as it may, few would dispute that it is heart-wrenching to watch your hard-earned money go down the drain. The best way is to learn from the process, and to keep refining your strategies for the future.

Firstly, understand that stock losses are simply part of the investing process, advised Yong. Accept that mistakes are inevitable and re-examine your investment plan again. “The objective of a detailed investment plan is that it helps you to think carefully when you are buying a stock, what is your timeframe, reward-to-risk ratio, cut-loss point and expected return for the stock,” she said.

When the stock price reaches your cut loss point, execute according to your plan. “The emotional disturbance is likely to reduce if you think that the scenario is within your control as the possible scenario is depicted in your investment plan,” she continued.

Next, you could also try to diversify your investment portfolio by limiting a smaller percentage per stock, Yong offered. This is so that the absolute value of a possible loss is minimised, which would reduce your pain as a result of the loss.

In sharing her final piece of advice, Yong encourages lifelong learning and investment in oneself. “Learn about investing by reading extensively and attending seminars. Challenge yourself to learn something new about investment. Do your own research and form your own opinion. The more you learn, the better your decision making will become”.

This article was brought to you courtesy of Focus Malaysia, a leading business weekly that publishes authoritative news and analysis on issues relating to corporate affairs, personal wealth, economics and current affairs.

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