A five step framework for when your stocks get crushed

The recent ASX reporting season has been nothing short of a rollercoaster, with share prices swinging wildly on results day. As a small-cap specialist, I've seen my fair share of reporting seasons, but this one was right up there for its sheer unpredictability and volatility.

The Reporting Season Rundown

If you weren’t confused by this reporting season then you weren’t paying attention. In the olden days - say more than 5 years ago - reporting season was a simple matter of getting the result and outlook right. We had a three-step framework. Firstly, we’d check earnings versus consensus expectations, then we’d check the cash flow to make sure management weren’t telling us any porky pies and finally peruse outlook. If you got ‘green lights’ on all three you knew your stock was going higher. And if you could only have one of the three then you’d take a green light on the outlook.

But here's where it gets interesting. We've seen a significant disconnect between earnings results and share price movements. Take Audinate Group (ASX: AD8) for example. Despite reporting continued weakness in sales and being borderline cash flow breakeven, its share price surged by a punchy +38% at one point. On the flip side, Domino's Pizza (ASX: DMP) saw its initial +20% share price rally go soggier than day-old pizza.

Volatility: The New Normal

This reporting season has been a masterclass in market volatility. The small-cap index dropped around -3% for the month and large caps fell more; down around -4%. Are we concerned? Not really. If you know what you own, volatility isn't something to fear.

For individual investors, it's worth understanding that market fickleness is the norm. Over the past two decades, US stock markets have fallen more than 10% from their 52-week highs on ten separate occasions. And the Aussie market is no different. Market corrections aren't the bogey-persons they're often made out to be. One way to think about the volatility is to say it’s a cost of doing business or, more formally, the price paid for the premium equities earn over cash and other assets.

A Decision-Making Framework for Retail Investors

How should retail investors navigate these choppy waters when their stocks take a nosedive? Here's a framework to help you make informed decisions:

1. Reassess the funny-mentals: Has anything fundamentally changed in the company's business model or industry? We also pay close attention to key executives leaving. The correlation between CFO resignations and subsequent downgrades is suspiciously high!
2. Look for quality: Companies with robust financials can generally bounce back after downturns. Ones that burn cash have less ability to bounce back as they’re dependent on favourable capital markets to fund their growth. Of course numbers don’t tell the whole story of a business and, by their nature, published financials are backwards looking but they’re a great place to start when defining quality.
3. Think long-term: oddly enough this is the hardest advice for younger people to take despite them theoretically having the longest investment horizons ahead of them. Often the market overplays short-term issues at the cost of long-term business fundamentals. Long-term earnings power always wins out.
4. Diversify: You don’t need a Noah’s Ark portfolio (two of everything) but the less you know the more you should spread your bets. There’s plenty of time to concentrate your portfolio as you build confidence and capability.
5. Avoid the timing trap: ASIC's analysis shows that retail investors attempting to time the market often end up on the wrong side of price movements. On more than two-thirds of the days when retail investors were net buyers, share prices declined the following day.

The Retail Investor's Playbook

Now, let's talk strategy. Firstly, resist the urge to trade. Trust me, even market professionals struggle to time markets consistently. I like to call myself the ‘world’s worst trader’ not just because it has a ring of truth but because it’s a reminder of where the real money is made; over the long term.

When faced with a significant drop in one of your holdings, take a deep breath and revisit your initial investment thesis. Has the company's long-term potential changed, or is the market overreacting to short-term noise? Have you done enough research prior to purchasing the stock and followed it long enough to tell the difference. Context is important and the longer you’ve followed a company, industry or management team the better placed you are to put new information into appropriate context.

Remember, volatility cuts both ways. While it can be unnerving to watch your portfolio value fluctuate, it also creates opportunities. Conventional advice is to “keep some dry powder” but given the inability to time markets discussed above, we tend to run pretty fully invested. This means we’re always on the lookout for our lowest conviction holding as the funding source for new ideas.

The Bottom Line

This reporting season has been a wild ride, but it's also a reminder of the importance of preparation. Remember the six P’s; Prior-Preparation-Prevents-Piss-Poor-Performance. For retail investors, the key is to stay focused on the long term, invest in quality, and to use volatility to your advantage rather than letting it dictate your decisions.

In the words of Warren Buffett, "Buy the dip and sell the rip”. Ok that prolly wasn’t one of Warren’s quotes but I’m sure you can dig out something the great man said about fear and greed. The question is, which side of the trade will you be on?

Join our webinar on March 20 for detailed insights on reporting season, our market outlook, and key opportunities at QVG Capital. Register here.