Every now and then, in Wall Street parlance, a stock “blows up.”
It might just be poor marketing or bad conditions for moving the company’s products, or it might be outright fraud. Either way, the people holding the bag–the empty shares left after the stock craters–are victims.
In those situations, most of us feel lucky. Many investors have no direct stock holdings, making all of their investments in mutual funds where, presumably, they are not the ones left wringing their hands and crying over losses.
But two recent stock blowups strike awfully close to home for everyone, and might make a lot of investors want to reconsider their personal comfort level with their investment strategy.
Mercury Finance Co. stock plunged from a January high of $15.75 per share to about $2 per share when it was revealed that the company engaged in fictitious accounting that overstated profits. Likewise, Centennial Technologies Inc. stock peaked at $58 per share in early January and has since declined to about $16.50, most of that plunge coming after the company launched an inquiry into the accuracy of its financial statements.
While these two companies are hardly big-name blue-chip firms, they were darlings of Wall Street, the kind of fast-growing firms that dot the portfolio of virtually every small-company and aggressive-growth mutual fund in the business.
“As a mutual fund shareholder, we have seen some geniuses walk into a fraud, and it has to make us wonder whether any portfolio is fraud-proof,” says Michael Stolper, editor of the Mutual Fund Monthly newsletter.
There is no concrete list of which mutual funds actually owned Mercury Finance or Centennial Technologies. Mutual funds only reveal their holdings twice a year, and those lists can be dated by the time they reach shareholders.
Investment managers do a lot of work to avoid having their stock picks blow up. They have analysts who talk to everyone from company executives to vendors, suppliers and competitors. Auto analysts often test-drive new cars; computer analysts often buy early versions of next-generation products to see if they like the concept.
Experts agree that there is little to be gained second-guessing an investment manager who’s facing a stock blowup. If you had the ability to outguess the manager, the thinking goes, you would have been putting your money directly into stocks; lacking the resources or acumen to do that on your own, the idea is to manage your fund selections, not nitpick the managers.
If your investments get rocked by some sort of scandal, there are four questions to consider:
– How big is the hit? Good managers often pick bad stocks; their winners simply outnumber their losers. But if they only hold a few stocks, and have a preponderance of bombs in a bad year, the volatility of their funds will be hard to stomach.
Gary Pilgrim of the PBHG Funds acknowledged that one of his firm’s managers held a big stake in Centennial, but sold out before the troubles came out.
“If it was 0.6 percent of our fund–and no stock makes up much more than that in any of our funds–and the stock had gone to zero while we owned it, the net asset value of the fund would change by 0.6 percent,” says Pilgrim. “That’s a loss, but it’s not a great loss. It might be a different story if the stock made up more than 5 percent of the portfolio.
“The way investors will react to it probably will depend on how the fund has done for them in the past and whether they think it can rebound.”
But if your mutual fund investments show sudden volatility on the day a scandal breaks or on an otherwise dull day on the market, you might want to call for an explanation. If the hit is so big–like the 5 percent in Pilgrim’s hypothetical example–that it makes you nervous, then you need to look seriously at the second question.
– Is the strategy of my investments right for me? One way that a mutual fund boosts its performance is by concentrating its bets, either in just a few stocks or in one or two industries. When things go well, the fund thrives; when something blows up, the fund nosedives.
There is nothing wrong with these kinds of investment strategies, so long as you understand the risks ahead of time. The wrong time to find out that your small-company fund made bets in tech stocks like Centennial was the day after the scandal broke and you lost a few more points in your net asset value.
“Once a stock blows up, the damage is done,” says Ken Gregory, editor of the No-Load Fund Analyst newsletter. “A lot of people buy funds without really seeing how they work, then get very nervous when something goes wrong–even if one or two stock blowups are pretty much the normal course of business for the fund in a year.”
– Am I sufficiently diversified? The current problems illustrate why diversification is more than just a topic to be kicked around by academics.
If you invest in individual stocks and can’t afford to spread your money into 100 issues, one blowup is very costly. If you hold stocks within several mutual funds, chances are that a blowup consumes a very small portion of your assets.
If your answer to the first question, on the size of the hit you take during a stock blowup, is “too big,” then chances are that you are not diversified enough to sleep well at night.
– Have I lost faith in my investment manager? Every manager makes mistakes. If you only allowed yourself to invest with those managers who never picked a loser, there would be no fund managers for you to pick from.
That being the case, consider this question carefully. Kenneth Heebner, of the CGM Mutual Funds, for example, runs concentrated portfolios and takes risky bets; the result has been some terrible years on the road to some of the best long-term returns in the business. A blowup in his fund might be cause for concern, but, given the track record, is neither unexpected nor enough to break your spirit.
Heiko Thieme, meanwhile, manages the American Heritage Funds, which last year took an 11 percent loss in a single day when Thieme had to revalue his holdings in some illiquid securities. Given a long-term track record near the bottom of all funds, an investor facing that kind of performance might finally have given up.
Says Gregory: “Most of the time, a blowup is an isolated event. It should not drive the way in which you view your fund manager. At the same time, if it happens to you and it is the incident that makes you realize that you are no longer comfortable with the manager’s approach, that would be the one time when a change might be in order.”
