You have no doubt by now heard about the market debacle which is Steinhoff. The price of the company dropped by an astounding -82% in the past five days, destroying hundreds of millions in value. Given the broad inclusion of the stock in the professional asset management space (unit trusts, ETF’s, pensions etc.), the devastating effects will be widespread for private investors. However, there is one simple rule that would have mitigated these risks entirely, the same rule that protected our clients from ABIL and the same rule that would have eliminated the risks associated with the devastating failure of ENRON in the US, which is being broadly used as a comparison. I’ve written about this rule extensively before here, but given the tumultuous drop in SNH, I thought a quick post revisiting this may be useful to some of you.
The secret to the rule is that there is no secret. It’s really very simple. Avoid stocks on the long side trading below their 200-day moving average, period. It’s a mathematical fact that a stock needs to first deteriorate below its average 200-day price before running into significant trouble. Generally, stocks don’t implode from new highs overnight, rather, there tends to be a gradual deterioration that starts to accelerate. For example, business conditions may begin to decline, which affects earnings and profitability, which in turn triggers insider and astute analysts selling the stock. As the difficulties mount, financial reporting trickery may develop to boost perceived performance. Eventually, the truth washes out and markets respond accordingly with massive selling. The 200-day moving average is highly effective (I quantified it in the post linked above) because it tends to trigger in the early part of the move, or when insiders and astute analysts start to sell. Have a look at the chart below for Steinhoff. We removed the stock from our tradeable universe in September last year. As a result, not one of our clients were exposed to the stock.
Here’s another example in ABIL. The reasons for failure are different, but the price behaviour is always the same, and price never lies. The landscape is littered with such examples and the evidence is clear, this simple technique really works. In fact, had you employed it, you would have outsmarted literally the entire professional asset management space in South Africa, that are now reeling from the losses. So next time you se a stock dip below it’s 200-day moving average, remember, the downside risks have risen considerably.