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Updated: Tue, 08 Apr 2014 08:00:00 GMT | By Bryan Borzykowski

What to do when a star performer in your portfolio takes a tumble

When good companies go bad


 (© Photo: Alex Wong/Getty)

CGI Group took much of the blame for Obamacare’s failure to launch (Photo: Alex Wong/Getty)

When Andrew Pyle bought shares in SNC-Lavalin Group in 2010 he thought he was buying one of Canada's best blue-chip companies. Over the next year the ScotiaMcLeod portfolio manager did well by the business; he made about 15% in 12 months. Then, in February 2012, something changed. Reports of improper payments , corruption and hasty exits by executives surfaced. SNC's stock fell by almost 17% in a week.

Pyle had to make a speedy decision: should he dump his shares at a loss or hang on? He had to determine if this was a temporary problem or if the company was now fundamentally different than what he thought he'd bought. After discussing it with his team-not everyone agreed-he decided to stick it out.

At this point, Pyle's decision looks like the right one. Though SNC-Lavalin has risen only slightly since March 2012, the company has $9 billion of business in its pipeline. Revenues, while down 4.5% year-over-year in the third quarter, aren't dropping off a cliff. "The stock has stabilized, its fundamentals are still sound and it should get better from here," he reasons.

Anyone who invests for long enough will be faced with a similar decision. The markets are littered with once great companies that have gone bad. For years Lululemon could do no wrong, but in the past 12 months it has tumbled by 25%, thanks to ongoing problems with quality control . Canadian tech darling CGI Group was motoring along just fine until people found out that it was the lead contractor behind the infamous Affordable Care website in the U.S. (It's down more than 10% since November.) Sometimes the share price drop is swift- witness Air Canada's 20% dive on Feb. 12 -other times it's more gradual, as in Lululemon's case. But in both situations investors have to decide whether to buy, hold or sell.

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There are many triggers for a sudden nosedive, says Eric Kirzner, Rotman School of Management's John H. Watson Chair in Value Investing. It can be the unexpected departure of an executive, a surprise lawsuit, poor earnings results or a drop in sales. Determining whether this is just an anomaly or something more serious is easier said than done, though. And emotion can work against you.

Numerous behavioural finance studies have shown that investors get attached to stocks, making them reluctant to sell when something goes wrong. A 1998 study by Terrance Odean, a professor of finance at the Haas School of Business in Berkeley, Calif., looked at 10,000 investors and found that people sell winners more readily than they do losers. Selling at a loss triggers regret, whereas gains make us feel good.

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To make the right decision, it helps to know a company inside and out. But that due diligence has to happen well before things go awry. Before you even buy a stock, take a three- to five-year view of a company, recommends Anthony Hammill, a portfolio manager with Broadview Capital Management. Try to figure out how much the business could grow over several years, how much it can sell, what margins it will make and what the balance sheet will look like. Having less debt can help a company roll with the punches.

If one of your holdings does run into trouble, you must determine why the company's suffering, says Kirzner. What is the story behind the setback? If you can't come up with a reason why the company is suddenly cheap, then you should carefully consider whether you want to hold on. "You do have to look at the financials and the metrics," he says, "but you need to ask yourself why the stock is depressed."

This analysis will lead to the key question: Has something fundamentally changed with the business? If the answer is yes, then sell. If it's no, then either hold or buy more.

For those who decide to hang on, that question will have to be asked repeatedly, adds Richard Nield, a portfolio manager with Invesco. He points out that in most cases, when a company reveals bad news, there's still more negative news to come. This is known as the cockroach theory. "When you find one cockroach, you usually find another," he says.

If the stock's future still looks bright, then a sudden price drop could signal a buying opportunity. However, it's often hard to tell exactly what's happening when a share price falls swiftly, especially in our age of information overload.

The best value investors shut out the market noise and buy when a stock looks cheap. They know the firm's fundamentals and can figure out if the panic is warranted. If it's not, then they'll buy in when the price drops to a desired threshold. Kirzner suggests buying a stock when its market capitalization falls below its intrinsic value. Danier Leather offered a classic example of this, he says. In 1998, soon after its initial public offering, the small-cap clothing company unexpectedly changed its Q4 results from a profit to a loss. The stock price fell 21% in a day. Shareholders sued.

While many investors stayed away after this, Kirzner says Danier was actually a fantastic value play. It was suddenly trading below the value of its cash and inventory, it had hardly any liabilities and, despite that one revision (which the company blamed on poor weather conditions), it was still making money. "There was no indication that the company was going to suffer," he says. Patient investors were eventually rewarded. Danier stock is up 293% over the past five years.

Should you determine the company hasn't changed but the stock is no great bargain, then simply keep what you have. Be prepared, though; it may not rebound as fast you'd like. SNC-Lavalin is only up 2.3% since March 2012. But based on his analysis, Pyle is confident it will eventually reach and surpass its former highs. "I did my due diligence and stand by the decision I made," he says.

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