Most investors would like to invest in well-managed companies that have a great growth history. However, as the share price of these companies almost always comes with a significant premium, the investors rarely decide to buy their shares, always waiting for a better entry point, which never seems to show up. Good entry points usually show up in periods of recession but in such periods the premium stocks usually decline much less than the majority of the stocks and hence investors prefer buying other stocks, which seem a much greater bargain and promise much greater yields when the economy recovers.
Therefore, the only time an investor can buy a premium stock at a significant discount is when the company faces a sudden headwind that is particular to the company. Surprisingly, even in such cases, most investors don't dare to buy the premium stock, as it takes great determination to be a contrarian when there is "blood in the streets." It also takes great knowledge and judgment to determine whether the company will recover from the headwind or it will incur a permanent crack in its earning ability. I will mention a few instances in which investors were able to purchase shares of premium companies at a great discount. These examples can be used as a guideline for future opportunities.
Almost three years ago, BP suffered the well-known Macondo accident, the worst pollution incident caused by oil ever. The stock lost 55% in just two months, falling from $60 to $27. At that time many analysts claimed that BP might go bankrupt or incur an aggressive buyout, as its liability might reach up to $40 B. Moreover, the company was supposed to incur a permanent hit on its earnings as it was expected to sell many of its assets in order to pay for its liabilities.
However, an astute investor would notice that BP could use the earnings of just two years to pay the full amount of $40 B. Therefore, one could purchase BP shares at an essential P/E ratio of 5 if one could be patient for 1-2 years in order to start receiving dividends and see the company grow its earnings to the pre-crisis level. Furthermore, BP has indeed sold many of its assets since the accident but it has mainly sold the low-return assets that are related with the downstream and the retail sector, which are much less profitable than its core field (upstream).
The stock of BP has risen by about 50% from its bottom and the company is now paying a dividend that corresponds to 5% yield and is more than half of the pre-crisis absolute amount. Despite the appreciation of the stock price, I believe that the current stock price still represents an investing opportunity.
BP was not the only stock that suffered from the accident in the Gulf of Mexico. Exxon Mobil (XOM) lost 20% of its value in the two months after the accident, as there was speculation that there would be severe restrictions in the oil production of all companies in the Gulf of Mexico. It is remarkable that Exxon revisited its bottom of the great recession of 2008 ($56) after the accident of BP while the rest of the stock market had climbed 50% from its recession bottom.
Exxon has maintained an exceptional growth record for more than 30 years and has been making consistent distributions to its shareholders all these years while keeping its debt at a minimum level. The astute investor realized that the consequences of Macondo would be short-lived for the other oil companies (apart from BP) and purchased Exxon shares at a great bargain price. The stock of Exxon has already gained more than 50% from its Macondo bottom. A very similar pattern was observed in Chevron (CVX) as well.
Yum Brands (YUM) recently incurred a health scandal in China, in which a few producers of KFC poultry used excessive levels of antibiotics. As the sales in China plummeted after the report, the stock fell about 15% (from $70 to $60) in less than two months. Given that half of Yum's sales come from China, I was actually surprised that the market panic was so limited.
On the other hand, YUM has a great record in earnings growth, having achieved an annual growth of more than 13% every year in the last 11 years ! It is a company that has completely ignored the cyclic phases of the economy. Moreover, according to its latest earnings release , 40% of its revenue comes from regions with a high growth rate (more than 10%), which confirms that there is still great potential for growth in the future.
The management of YUM projects a mid-single digit decline of earnings in 2013 due to the scandal in China but it also reassures its shareholders that the brand name will soon be restored, the scandal will fade away and the company will return to its normal growth rate. The stock of YUM has already gained 8% in the last two weeks, revealing that the market was too eager to take advantage of the bargain price.
Apple (AAPL) has lost 35% of its value in the last five months, mainly due to its declining profit margins and the market perception that the company cannot perpetuate its great innovations. The company is greatly managed so some investors were looking forward to a price correction in order to purchase shares at a seemingly bargain price.
However, in my opinion, Apple is not suffering from a one-time headwind. The company that has been making monopoly-like profits thanks to its exceptional innovations is starting to face increasing competition from other companies, which is always the case in high-profit markets. I believe that Apple cannot sustain its past growth rates in the hugely competitive tech sector now that Jobs is gone and hence I consider the current stock price a risky entry point.
At some point the smart investor will be given the chance to purchase shares of even the greatest companies at a bargain price. If there is a one-time headwind that the company will soon leave behind, then the investor should be decisive enough to pull the trigger and buy the shares while the others are selling them in panic. However, the investor should always use good judgment and perform due diligence to determine whether the company will recover from the headwind or it will incur a permanent damage in its business.