Why Good Stocks Go Down

 | Oct 04, 2012 | 1:00 PM EDT  | Comments
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Stock quotes in this article:

hpq

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jpm

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amzn

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dell

My fellow Real Money contributors will probably agree that when readers come to us with questions, some of the most common ones are in reference to a stock we have discussed whose share price has gone down. Declining stock prices are no fun. The human brain is wired to expect positive outcomes. Negative outcomes, as we often see, can often lead to very irrational behavior from investors.

Many would say that stock prices decline because of bad news coming out a company. Indeed, yesterday, Hewlett-Packard (HPQ) CEO Meg Whitman suggested that Hewlett-Packard will likely experience lower growth in 2013 and perhaps longer. That news sent shares down nearly 20%. It's fair to say that on the basis of Whitman's comments, Hewlett-Packard's future cash flows are likely to be lower, and as such, the intrinsic value of the business may need to be adjusted downward. Whether that adjustment was fulfilled by the 20% haircut that the stock took yesterday is anyone's guess. Mr. Market has a habit of reacting to the news first and digesting the actual information later.

Another illustrative example is JPMorgan (JPM) and the trading loss of $3 billion to $4 billion that the company announced a few months ago. In just a couple weeks, shares plunged from $44 to $31, or more than 30%, on a loss that represented less than 3% of tangible equity. Mr. Market reacted first. Since then, the information has been digested, and shares in JPM are now trading for $41, up more than 40% in less than three months.

Another head-scratchier is Amazon (AMZN), which seems to climb higher even when the company reports weaker-than-expected operating results. Because investors have come to believe that Amazon is the online Wal-Mart (WMT) (which is likely going to be true), it justifies a trailing price-to-earnings ratio of 300. But because Amazon shares are going up, no one questions the validity of the price movement.

Yet declining stock prices are always over-evaluated to extreme scenarios. To most investors, a falling stock price automatically means that a company is permanently tainted. Indeed, Hewlett-Packard may be impaired, but instead of letting the falling stock price provide you with all the information, dig a little deeper. In the short term, the stock market is a voting machine. If the mood surrounding a stock is not positive, most analysts don't seem to care much for the fundamentals. Yet if the core business is not permanently impaired, then any opportunistic investors should welcome a declining stock price with open arms.

This is indeed happening with Dell (DELL) today, and as a result, investors are losing patience. Dell is an example of a cheap stock that is getting cheaper. In this case, the "core" business of selling PCs has become permanently impaired to a certain extent, thanks to mobile computing. So the frustrated Mr. Market sends the stock price lower. Yet over the past year, Dell's equity has increased from $8.6 billion to over $9.7 billion. The company is repositioning itself as a service provider as opposed to a product provider. The transformation is causing hiccups, but the overall model is working. Investors are going to have to be patient. For those who are, I suspect the outcome will be very rewarding.

I suspect that if more market participants spent more time understanding the businesses they invest in, the urge to sell at the first major stock price decline would be reduced significantly. If you invest carefully and know what makes the company tick, declining stock prices are less likely to become bothersome. To be sure, we all make bad investment decisions or overlook a valuable piece of information that dictates the immediate disposal of a stock. But if you invest at a good price, a stock-price decline gives you an even better price.

The market is not always correct. I would not touch Amazon at the current price, because in my opinion it is overvalued, and that is a legitimate cause for a stock-price decline. But if you buy at an attractive price and look beyond the short-term noise, you get a better understanding of why a stock price declines and how to handle it.

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