Plunging share prices often reflect deep trouble in a stock’s underlying business. But a sharply falling share price also attracts many investors who are fishing for a bargain.
But trying to pick a bottom on the chart of a falling share price is fraught with difficulty. On top of that, any investor flirting with declining share prices is presumably looking for the green shoots of recovery in an enterprise that will lead to the stock market reassessing a firm’s valuation and sending the share price back up.
Downside potential
You’ve got to be an insightful analyst to get that one right. Get it wrong, though, and your investment could go down with the ship. But just how low can the share prices of troubled firms such as Sirius Minerals, Thomas Cook and BT go? The short answer, I reckon, is that they can go to zero. Indeed, all shares have the potential to become worthless. That might seem far-fetched with these three, but let’s skip through a potential scenario that could drive each share price to nought.
Wannabe polyhalite producer Sirius Minerals has no sales or profits and relies on securing outside funding before it can even build the mine it needs to extract its product for sale. Securing funding has proved to be difficult. Conditions in the financial markets could deteriorate further making funding impossible. Operating funds could run out and the firm may go bust.
Meanwhile, Thomas Cook is finding it difficult to trade profitably in an over-competitive and cyclical market. It needs refinancing. Trading could deteriorate further because of a cyclical slump in the market and even if the firm secures refinancing from outside investors now, it could still make trading losses. Investors may give up on the company and refuse to refinance it again, leading to bankruptcy.
And BT’s revenue, earnings and cash flow have been trending down for some time. That situation could continue and accelerate if a general economic slump pulls the rug from underneath the firm’s business activities. Meanwhile, the company carries a large pile of debt and a big pension obligation. The finances could become so poor that the company is not worth saving and it goes into administration.
Protect your investments from a wipe-out
Generally, I think it’s a good idea to think about the downside potential risks with any company that you buy shares in. But you can mitigate some of the risks by looking for good quality stocks such as those with underlying enterprises that have a strong trading niche in their markets.
A decent record of trading, strong balance sheet and a positive outlook can also help you pin down better shares. Or you may be more comfortable going for an index tracker fund, or managed fund, which would dilute the risks of investing in any single company because your funds would be spread across many shares within the fund.