Value Stock or Just a Dud? How to Tell
10/14/2010 12:01 am EST
I recently received a phone call from a friend asking me about my opinion on American Express Company (AXP). He was asking me based on his knowledge of my preferred long-term strategy: I like to buy good companies that have just come out with bad news and are under extreme pressure, which causes them to trade down hard—20%, 30% 40%—in a matter of days to a week or so. This is what happened to AXP, which fell from $44 to $37 in just a few days on negative news, as you can see below.
The reason I like this, along with other recent big, bad-news-led selloffs—such as Schlumberger Limited (SLB), on speculation it spent too much acquiring SSI; Toyota Motor Corporation (TM), due to a large recall; and BP plc (BP) and Transocean Ltd. (RIG), due to the Gulf oil spill—is that all of these stocks give traders and investors the rare opportunity to buy value at a discounted price.
The reason that this is an increasingly rare opportunity is due to the evolution of the markets, led by technology and globalization. Today, there are more market participants than ever before, and they are up-to-date and versed on all of the current data more than ever before thanks to the Internet. This leads not only to more liquid markets, but also to more accurately priced stocks.
Therefore, the only time that one typically sees an undervalued stock is during a time of irrationality. It now takes something more than “regular” bad news to cause the panic necessary to trigger the irrational selling that creates an opportunity to buy a stock at a price that is discounted to value. Sounds simple enough, right?
Well, there are a couple of factors in play after the bad news comes out:
Choosing the Right Stocks
First, how do we determine the difference between really bad news and deadly news, for example, the difference between the bad news Transocean received and the bad news Bear Stearns received?
Unfortunately, there are no specific guidelines, so judgment becomes a critical factor in the decision-making process. The cardinal rule here is that if you are not sure, then pass on the score.
You must realize that this opportunity is a very risky trade and not for everyone. The news that was released was bad enough to make the vast majority of investors and traders out there sell or at least move away from buying, which is the reason the stock lost so much value so quickly.
You have all heard the term “catching a falling knife,” and I am sure you are all aware of the risks of doing so. By stepping in and making a purchase against the heavy market sentiment of the time, you are going against the prevailing school of thought. You are saying that the market and all of the intelligent people in it are wrong and you are right. It takes a lot of confidence, maybe bordering on cockiness, to make this trade.
And there is skill involved when it comes to dissecting the news. For example, Transocean was my favorite stock for a while after the Gulf oil spill news broke.
The question was, why this stock in this situation as opposed to another stock in another situation? As I saw it, Transocean was a solid company with very good earnings, not to mention that it is the largest offshore driller in the world. Oil spills have happened before, and will happen again, but there is no way in hell that we were going to stop drilling for oil and switch to some other form of energy overnight due to a spill. Further, you know a company this big and this well run will have insurance ready to cover a problem like that. RIG trading down 50% ($90 to $45) in just a couple of weeks was definitely an overreaction. I was willing to take this bet because I knew that we were not giving up on oil.
On the other hand, with Bear Stearns, I had no idea of the size of the debt Bear Stearns had on its books, nor was I sure of the leverage multiple they were trading under. That uncertainty made me steer clear.
Timing Your Buy
The next factor is determining when to jump in. This can be as difficult and treacherous as deciding on the severity of the news. If you jump in too early, you may have to handle a considerable amount of pain before the stock finally bottoms out. If you hop in too late, you may find yourself chasing the stock as it bounces up as quickly as it traded down and you miss the greater part of the discounted value that you were seeking to capture in the first place.
But there is an answer to this dilemma. The answer is a good working knowledge of technical analysis, especially in the area of support and resistance. With the use of historic support levels, combined with a scaling-in buying strategy, you can greatly increase the odds of getting in at the right time and price level. Now as you know, in the markets, there are no guarantees, but successful investors try to put the odds in their favor, and that is exactly what the ability to locate support points using technical analysis does and why it is so important here.
Trying to find value in this market is not all that hard as long as you are willing to pay for it. However, trying to find discounted value in any market is much more difficult…and riskier. With this increased risk, an investor would be well advised to learn how to use options to hedge a stock position—or better yet, to replace the stock position—with a stock-replacement option.By Ron Ianieri of ThePhoenixPortfolio.com