What to Do When Your Stocks Are Underwater: Learning from the Masters' Experiences

In the face of a significant short-term decline in held stocks, investors naturally find themselves beset by anxiety and confusion: What underlies the drop?

Has there been a substantial shift in the company's fundamentals? And what strategies should be employed to safeguard existing investments amidst market volatility, potentially even capitalizing on a potential rebound?

This concern is particularly acute given recent pullbacks experienced by NVIDIA and the broader US equity market, leaving stockholders' nerves frayed.

In the realm of investing, Warren Buffett's name serves as a beacon for value-oriented investors, guiding their navigation through market waters. Renowned for his long-term holdings and contrarian approach, the "Oracle of Omaha's" association with Occidental Petroleum constitutes a market tale replete with dramatic twists and turns.

2019 saw global energy markets roiled by intense price fluctuations, with Occidental Petroleum, an American shale oil behemoth valued at tens of billions of dollars, weathering a sectoral trough. It was then that Buffett, with his keen eye for undervalued gems, discerned the latent worth within the company. He initially committed $10 billion to purchase Occidental’s preferred shares, an investment resembling bonds that delivered steady dividend income and a measure of safety to Berkshire Hathaway.

Yet, this was merely a prelude to a more assertive move. Buffett went on to demonstrate his audacity by gradually building a position in Occidental’s common stock. In Q4 2019, he made bold purchases, culminating in an approximately $830 million outlay by year-end, amassing nearly 19 million shares. However, fate seemed intent on testing the mettle of this investing maestro.

The COVID-19 pandemic stormed the world early in 2020, sending financial markets into a panic and causing energy demand to plummet, driving oil prices to historic lows. Occidental’s share price tumbled in tandem, subjecting Buffett’s investment to immense pressure.

Confronted with the unforeseen adversity, even Buffett found himself compelled to make a difficult decision. In response to paper losses, he opted to temporarily “cut his losses” by trimming part of his stake in Occidental, thereby mitigating portfolio risk. This move, though seemingly at odds with his well-known “buy-and-hold” philosophy, exemplified his adaptability in the face of market shifts. Yet, the narrative did not conclude there.

Fast forward to 2022, with the global economy rebounding and energy supply-demand dynamics undergoing a significant reshaping, oil prices staged a robust recovery. Occidental’s operating conditions improved dramatically in this backdrop. It was at this juncture that Buffett once again demonstrated his uncanny timing, deploying over $7 billion in just two weeks to accumulate a 14% stake in Occidental, catapulting his ownership percentage and signaling resolute faith in the oil major’s prospects. This maneuver not only underscored his continued bullishness on the traditional energy sector but also served as a vivid testament to his profound understanding of market cycles.

Amidst short-term price fluctuations, one should not readily abandon their assessment of a quality company's long-term growth potential. Instead, the focus should be on whether the company's fundamentals have deteriorated, and if future valuations appear excessive, whether the anticipated growth can justify them.

Buffett's decision to increase his stake in Occidental was not solely based on its stock price trajectory but rather on a thorough analysis of its financial condition, business strategy, and industry standing. When dealing with underwater holdings, investors should consistently monitor corporate developments to assess whether fundamentals remain sound or show signs of improvement, using these insights as crucial inputs for deciding whether to hold or adjust positions.

Even for long-term investors like Buffett, tactical rebalancing in response to market conditions and portfolio needs is essential. While he reduced his Occidental position during a sharp decline, he quickly ramped up his investment when the company's fundamentals improved and market conditions became favorable. This underscores that while maintaining a steadfast value thesis, investors should also exhibit flexibility, opportunistically adjusting their holdings to exploit market volatility and optimize cost basis.

In addition to purchasing Occidental's common stock, Buffett employed instruments like preferred shares and warrants to secure stable returns and retain the right to buy more shares at a lower price in the future. Investors can emulate this approach by judiciously using derivatives (such as options and warrants) to hedge risks or create ancillary income opportunities.

For instance, faced with a declining stock, they might consider selling out-of-the-money call options to recoup some premium, without fully covering their underlying position; if still desiring to accumulate shares on weakness, they could explore selling higher-strike calls while simultaneously buying lower-strike puts to establish a synthetic long position at a more favorable net cost.

Firstly, even Warren Buffett has experienced short-term losses historically, so occasional misjudgments on our part are entirely normal, given the dramatic nature of stock price movements. Remaining steadfast in our approach is often the best course of action. To make this determination, we can employ a decision tree:

Over the long run, stock performance is driven by the product of earnings per share (EPS) growth and valuation expansion, augmented by shareholder returns. We must assess the company's financial health, business strategy, and industry position. If these fundamentals paint a generally positive picture, with particular emphasis on the robustness of revenue and profit growth driving EPS changes, our next step is to examine "valuation."

For a growth-stage company, we need to gauge whether its projected long-term growth can justify its current valuation.

Put differently, can investors envision what the company will look like several years hence—will it boast higher revenues and profits, or will it be on a downward trajectory? If we conclude that future growth can indeed absorb the current valuation and the company will continue to grow, our task becomes "optimizing the cost structure through trading strategies." These may include:

For investors who question the investment merit of a company after reassessing its value, believing that long-term commitment would be unprofitable due to either poor fundamentals or challenging trading dynamics, exiting the position may be the prudent choice.

For traders who find themselves caught off guard by a downturn and lack a strong grasp of fundamentals, the focus shifts to examining their initial trading strategy:

Thus, for fundamental investors, analyzing company fundamentals, valuations, and potentially leveraging option strategies can help navigate downturns and refine their approach. For traders, staying true to their established trading discipline is crucial for sustained success.

There is significant overlap between these two investor types, and those adept at combining fundamental analysis with trading techniques resemble masters versed in multiple schools of thought. Such investors must assess fundamental trends, study trading psychology, and diligently execute well-designed trading plans, which can greatly enhance their investment outcomes.