Often times, it pays to swim against the tide. But how do you tell the difference between a cheap stock and a bargain?
When teen-focused retailer Aeropostale (NYSE: ARO) announced dismal first-quarter results in May 2011, and its shares dropped more than 15% in just one day, many investors gave the company a quick look to see if that sell-off was overdone.
After all, this retailer has a very impressive track record over the last decade, and everybody knows that teenagers can fall back in love with a retailer if the merchandise gets better. That’s what cruising the mall is all about.
If you follow a simple blueprint, then you may be able to know if you should buy in right after everyone sells. Here are my four rules that lead me to zig when many may zag.
[InvestingAnswers Feature: The Very Best Value Plays for Patient Investors]
1. Are the Problems Fixable?
Retail stocks are an especially fertile area for bottom-fishing. Though it may take a few quarters, better merchandising can bring the customers right back. Retailer Macy’s (NYSE: M) lost its touch with consumers in 2006 and sales started to weaken. Its stock plunged from $45 in early 2007 to just $6 in late 2008. The final blow came on November 18, when third quarter results showed that consumers were holding their purse strings tight.
But management also noted a whole host of initiatives that would cut costs, improve consumer appeal and reverse the tide of negative same-store sales results. That final plunge (known in Wall Street parlance as “capitulation”), coupled with a clear management plan, turned out to be a great time to turn bullish. Shares have risen more than 400% since then as management has delivered on the game plan it outlined.
In the case of Aeropostale, more caution is warranted. Management has admitted to a bad set of merchandising choices and has yet to come up with a plan to help boost sales. But keep a close watch -- shares are quite inexpensive, and any announced plans to upgrade their clothing line could be a catalyst for a turnaround.
If you know a teenager, ask them to keep an eye out for what Aeropostale is up to at the mall. Positive feedback could help you decide shares if the merchandising appears to be broken.
2. Too Big a Sell-Off?
Investors are a very emotional lot. They’ll all sell at the same time if a company badly stumbles on a quarterly report. That’s why I look to see what the new lower stock price means in terms of key value measures.
Did the company’s market value fall below the book value of its balance sheet? Is the stock now noticeably cheaper than rivals on a price/sales basis? Was a quarterly shortfall simply due to major orders that were pushed into the current quarter? An answer of yes to any of these questions could bring out the value investor crowd.
The key is in how management responds to a current bout of share price weakness. They may start a stock buyback if the company has a strong balance sheet. They may also announce a restructuring that takes lots of costs out of the business. Or they may speak of a refreshed product cycle that will soon reach customers. All of these factors would make me bullish when others have turned bearish.
3. The Merger and Acquisition factor
Right now, we’re in the midst of an acquisition boom where many larger companies are seeking out smaller and mid-sized companies to help bolster growth. That’s why it pays to see what’s happening in an industry that contains a stock that has just sold off sharply.
If rivals are getting snapped up, then you can get a clear sense of how companies are being valued by investors outside of the stock market. Many aggressive companies and hedge funds seek to make an offer for a company when it is distressed. Liberty Media recently made a surprise offer for Barnes & Noble (NYSE: BKS), pushing shares of the beleaguered bookseller up more than 30% in just one day.
Much of the merger and acquisition activity is taking place in the high-tech industry, making that group an especially fertile area for quickly rebounding stocks.
(For help on finding the most profitable acquisitions, check out Tips on How to Analyze an Acquisition Announcement)
4. Insider Buying
I like to look at recent purchases by executives and directors at companies (which you can find at insiderinsights.com and other insider-focused sites). If a stock has just plunged and an insider writes a large check to purchase shares, then that tells me that the company’s prospects are not as bleak as the discounted stock might indicate.
The key here is to utilize the first three lessons after insiders have stepped in. Does management have a clear solution to fix recent problems? Are they making a convincing case that the problems will be short-lived? If so, then the stock has likely found a floor and may soon crawl its way back up.
[For more tips visit The Profit Secrets of Insider Trading]
The Investing Answer: Stocks tend to fall very quickly and rise very slowly. It’s not hard to find a handful of stocks every day that have quickly lost 10% or even 20% of their value. I like to quickly look at what’s driving the sell-off to see if investors have reacted appropriately.
But time is of the essence. A stock that has fallen quickly may start to perk up in subsequent sessions as value investors pounce. It may take quite a while for shares to return to their former heights, but it’s always nice to get in on the ground floor of these upward moves.
