How to survive a shock

Buying individual stocks is a risky business, so what can you do when a stock you own is hit by unexpected bad news? John Stepek explains.

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This is the worst of all possible strategies

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Last month investors in Petrofac got a nasty shock when the FTSE 250 oil-services group suspended its chief operating officer. The move came as part of a wider probe by the Serious Fraud Office (SFO) into Monaco-based Unaoil, a consultancy that is alleged to have paid bribes on behalf of oil companies. Petrofac's share price tanked it's now down nearly 60% on the year. This is another reminder that buying individual stocks is a risky business, and that even the biggest players can come a cropper. But what can you do when a stock you own is hit by unexpected bad news?

First, don't avoid the issue. Losing money is painful, so you might find it surprisingly tempting to close your eyes, hang on and hope. But one notable statistic from The Art of Execution by fund-of-funds manager Lee Freeman-Shor should help to change your mind. Freeman-Shor looked at nearly 2,000 individual investments made by managers in his fund between 2006 and 2013. Of 131 investments where a share price had fallen by more than 40%, none recovered sufficiently to make back the lost money over that time period. So, as Freeman-Shor notes, when you have a big loser in your portfolio, you have two choices: cut your losses fast, or buy more and aim to profit if the share price rebounds.

The case for selling is simple. There is no point in throwing good money after bad. Crystallising a loss right away stops it from turning into a bigger loss. How can you make the "sell" decision easier? Freeman-Shor advocates using a stop-loss. This is simply a set price at which you will sell, no matter what. He suggests targeting a price of 20% to 33% below your purchase price (or from a recent post-purchase peak). That should give enough leeway to avoid being shaken out by everyday volatility. The benefit is that you don't have to second-guess yourself if the target price is breached, you sell. Of course, ideally you have this target price in mind in advance.

The case for buying more is trickier. You need to look at the stock afresh and ask: would you buy at today's price, in today's conditions, knowing what you know now? If the answer is no (or "maybe, but...", as Freeman-Shor puts it) then you should sell. This isn't easy, but the point is to force yourself to act if you aren't prepared to buy more at the current, lower price, then there is no rationale for clinging to the holding you already have.

If you think the stock is still good value, you should top up. This is one reason not to invest too much in any one stock so that you have the ability to top up if desired, without having too many of your eggs in one basket. I've looked at how you might approach the question of Petrofac below.

Is it time to sell out of Petrofac, or should you top up?

But what if you are still holding on? The share price is now at levels last seen in early 2009, and is not far off its 2008 low of around 270p (near the height of the credit crisis). Its market capitalisation has more than halved since the start of the year from around £3.1bn to £1.2bn.

Oil industry analysts reckon that if the Serious Fraud Office does uncover wrongdoing, then the group could be fined up to $800m. As Lionel Laurent of Bloomberg Gadfly notes, the slide in the company's value already far exceeds that, and it has the financial resources to pay up if necessary (it's paying out around $225m a year in dividends for a start). Its lenders have also continued to back the group. So that's the bull case the potential financial bad news is in the price, and in terms of sentiment, well, things don't get a lot gloomier than they felt in early 2009.

However, there is a "but". The risk is that the case drags on (the investigation could run into years) and that during that time, management is distracted, and new business is harder to win, in a sector that is already under pressure from the uncertain outlook for oil prices. On balance, a lot of bad news is priced in, but I'd want more clarity on the impact of the SFO case before I would consider investing (Full disclosure: I don't own Petrofac).

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