Tuesday, September 9, 2008

Should Value Investors Use Stop-Losses?

Stop-loss orders are often recommended to investors of all types, especially those who aren't always watching the market. Basically, a stop-loss order works as follows: if a stock drops below a certain level (set by the investor), the stock will automatically become a market sell order. The goal is to protect investors from a stock price drop that is more than they are comfortable stomaching.

But for value investors, are stop loss orders useful? They can still serve their purposes in many cases. For example, if bad news for a company gets released at 10:06 am, and the stock goes into free-fall, a stop-loss could get an investor out of the company at 10:09 am while he's out having a coffee.

On the other hand, value investors tend to understand what they are buying (lowering the risk of an unexpected impairment), prefer companies with low debt to capital levels (lowering the risk that a company can't unexpectedly make a payment), and prefer to take advantage of volatility (rather than fall victim to momentum trading). As such, they are less likely to benefit from the protections offered by a stop-loss.

On the other hand, value investors are still prone to the negative effects of stop losses: When the market panics unjustifiably, stop loss orders kick in and investors are exited from their positions at prices far inferior to what they may have been willing to sell for!

Consider what happened yesterday to the parent company of United Airlines (NASDAQ: UAUA). Panic swept the market after a false rumour of bankruptcy spread throughout, causing the stock to drop 99.92% (from $12 to one penny!). Following news that the rumour was false, the stock returned near its original level. Those with stop-losses got exited at terrible prices, as the stock dropped like a rock. Even if you had a stop loss at $10, it would have got filled much lower since there were no buyers at $10 during this panic.

For reasons we've discussed here, airlines do not generally constitute great value investments. Nevertheless, the concept applies to any company where market panic takes over despite no change in company fundamentals. When using stop-losses, this added risk should be considered.

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