Reader question: Is a falling share price a negative indicator?

I was chatting to a reader about share prices and was asked whether I consider a falling share price to be a negative indicator. Surely, if the market is a combination of hundreds of individual investors expressing their opinions then a falling price indicates that more people have found a reason to sell than to buy; therefore some bad news is perhaps imminent (or has already been announced) regarding a company.

How true is this?

There is, of course, some measure of truth but on balance, I believe the efficient market hypothesis (which states that the market is an accurate reflection of all available information) to be rubbish. It\’s one of those ideas which sounds like genius on paper but in reality just doesn\’t stand up. The only way the theory would work is if all participants in the market had identical access to perfectly correct information which is slightly problematic. For one thing, information is shared through a huge range of mediums and is accessed, interpreted and acted upon in different ways by each agent in the market.  For another, humans are not perfectly rational beings – we act on emotion and conflicting experience all the time, as evidenced across the entire spectrum of human enterprise.

Having said this, there are some price movements which are undeniably more rational than others. If a company announces an agreed buyout at a ten percent premium to the current market price, share prices in the market will generally rise to that level as investors seek to \’lock in\’ a guaranteed gain. Likewise, if a company announces a huge and unexpected fine from authorities, the share price will decline. But by how much? Some investors work from future cashflows, which will be impacted by the fine and so will discount by a set margin. But this margin will differ between different investors. Some will trust that the existing management team has the situation under control and so will be willing to hold the shares. Others will follow the maxim \’there\’s always more than one cockroach\’ and so sell the shares on fears of further negative announcements. Who is to know which side is right?

It is because of this challenge that I don\’t consider a share price movements to be a reliable indicator of anything over the short term. Over the long term, however (say 2-3 years and longer), I change my position slightly. Companies where listed prices are persistently falling indicate a business which is likely to be facing long-term issues such as declining revenues and margins, a weakening balance sheet and potentially rising competition. In these instances I will always carefully examine financial trends before making a conclusion and will always spend plenty of time asking myself what it is that the market knows that I don\’t (sometimes this \’knowledge\’ is simply unfounded fear but other times it is a real red flag).

So if market movements aren\’t important in the short term, what is?

Fundamentals. How much is the company selling and how much is it likely to sell in future? How much profit does it generate and is the likely to rise or fall over time? Who are its competitors and what are they doing? Asking and answering these questions is a far better way to spend your time than worrying about a wiggly line on a graph.

As a species, most of us are predisposed to do something. Sitting on our hands is often portrayed as weakness and indecision, whereas confident action (even if incorrect) is generally encouraged. When it comes to investing, this often manifests as a constant stream of buy and sell actions. Investors find a share, it grows into a small profit, they sell it and move on. Or they suffer a falling share price, lose conviction, sell and move on. Unfortunately, neither of these options leaves much room for holding onto the true diamonds in a portfolio – the firms like Games Workshop that\’s grown from £1.24 in 1994 to over £71 today – an annualised growth rate of nearly 17%.

Of course, looking backwards is easy but imagine going on that journey as an investor. It wasn\’t a straight upward line; the price decline from over £8 to £1.17 between 1998 and 2000, and from over £7 in 2005 to £1.23 in 2008. If looking at the share price alone, those movements would be more than enough to terrify most investors into selling even halfway through the decline, let alone holding on through both!

When you\’re holding an investment going through such precipitous decline it\’s imperative to stay calm and thinking about the big picture. Why did you like the investment in the first place? Why did you think it offered good long-term value? Are these things still evident or has the situation changed?

Take time to re-run your analysis and make a considered, informed decision. Review recent communications from the company and try to ascertain whether the price movement reflects a new truth or whether its simply market noise. Investment decisions shouldn\’t be taken in a rush – whatever the situation today, it is unlikely to have materially changed tomorrow but by rushing, you increase the likelihood of making a serious mistake.

I also find great value in considering the security in terms of my entire portfolio rather than in isolation. I\’m a firm believe in holding a diversified range of assets, both across geographies and sectors. As such, the security likely represents the \’best in class\’ as far as I\’m concerned – so if I\’m ditching it then I need to ensure I\’m not losing desired exposure to a sector or region.

I\’ve written before about the value of diversification (I don\’t think I\’d ever sleep again if I held one of those portfolios comprised of a handful of equities). I find diversification to be a fantastic hedge against my own analytical mistakes and unexpected events; it acts as a wonderful shield to take problems head on without causing panic and destruction across the wider portfolio. Certainly, it dilutes my potential returns but I find the defensive qualities more than adequate compensation for this. 

Conclusion

So if a share price is falling, don\’t panic, don\’t convince yourself you\’re holding a crock of c**p, just stay calm and logical. A falling share price may be nothing more serious than random \’market walk\’ and may soon reverse. It might be a sign of something more. But either way, only looking at the fundamental facts will tell the truth.

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