Thus far, 2013 has turned out to be a stellar year for equity investors. The Dow Jones Industrial Average has just closed out its best week since the resolution of the late 2012 fiscal cliff debate. The S&P itself is up by nearly an amazing 20%. The Nasdaq is up by 23%. Over 95% of S&P 500 companies are up for the year.
Knowing when to hit the "buy button" is generally far easier that knowing when to hit the "sell button". Once an investor commits his time to research and understand a stock, it often becomes psychologically difficult to part with that stock, even when there are clear signs which indicate it is time to sell. This can sometimes be because the stock is still rising and the investor is afraid of selling too early. Other times it is because a stock has fallen and the investor is reluctant to take a loss or sell below a recent peak.
For those with an interest in the subject, there are numerous articles which can be read on the subject of "behavioral finance". Many of these come from the much respected CFA Institute.
This recent article highlights the findings of the CFA Institute in terms of the most common mistakes by investors. Most people reading the article will quickly find examples of mistakes that they make, often without even realizing it.
Today we look at three examples of stocks which have experienced volatility around recent developments. These developments mean that many investors may strongly suspect that they should sell but they may still be very reluctant. The usual reasons for reluctance are:
refusal to lock in a loss
readjusting price targets to ever higher levels
"ostrich syndrome" (ignoring bad news, hoping it will go away)
irrational tax avoidance
Men's Warehouse (MW) - "Sell if you're long, but do not go short"
Men's Warehouse is a stock which had given investors numerous sell warnings well before the stock plunged. Yet in the current bull market, most investors refused to heed these warnings and suffered a painful loss as a result. For most investors, the loss was entirely unnecessary.
Men's Warehouse rose almost 40% from under $28 in the beginning of March to just over $39 last week. Holders who bought around the beginning of March saw almost half of this gain wiped out on Thursday after the company reported disappointing earnings for the second quarter and revised its full year outlook downwards.
While holders of the stock clearly hoped for better earnings, there was plenty of evidence to suggest that taking profits before earnings were released would have been a fairly obvious decision.
The first series of hints came from disappointments by competitors. Clothing retailers across the board have been performing horribly over the past few months, all due to disappointing results. Aeropostale (ARO) fell 40%, since the end of July. Direct competitor Jos. A Bank (JOSB) fell 8 % on August 16th after issuing a profit warning the night before. Heavily shorted Franchesca's (FRAN) fell 25 % after missing earnings on September 4th, and Abercrombie (ANF) fell 20 % after guiding third quarter earnings to be 60% less than estimates on August 22nd. The guidance was so bad that it qualified as the second worst of any major company this quarter. In other words, anyone watching the apparel retailers should have realized over the last few months that the sector was experiencing extreme weakness.
But the competitive landscape was not the only set of clues. There appears to have been some board room drama in the past few months, as Executive Chairman George Zimmer (the guy from the commercials) was terminated from his post in June. As if all this weren't enough, there were more than $6 million worth of sales from multiple insiders in late July and early August.
The fact that these disappointments all coincided with a multi year high in the share price for Men's Warehouse should have been cause for concern. After all, the share price was already so high that even good results were unlikely to push it much higher. By contrast, poor results delivered a disproportionate punishment to shareholders.
The first question is "why didn't investors sell ?" It is likely that many investors did not sell simply because the share price did not react immediately to the bad news that was emerging. It is also likely that as the share price rose, some investors simply readjusted their targets ("got greedy") and hoped for further gains. In addition, the size of the gain meant that many investors may have continued holding to minimize the tax burden. But with much of the gain having evaporated, paying taxes has now become much less of a concern.
The more important question is "what to do now ?" Men's Warehouse is down by around 10-15% from its recent highs. It will likely take at least a few quarters before the market gains better visibility on demand and its management issues. As a result, there is little upside to holding Men's Warehouse, and there is still likely to be moderate additional downside. For those still holding, it is still a better decision to sell rather than experience further downside. It was a mistake to continue holding this stock through earnings given all the bad news that was emerging. That mistake should not be compounded by a second mistake which is "refusal to lock in a loss" (ie. blindly hoping that the stock recovers).
Neonode (NEON) - "Sell if you're long, and consider going short"
As with Men's Warehouse, shares of Neonode are up by around 33% since March. The key driver has been a number of press releases signaling potential new contracts in 2014. Also like Men's Warehouse, Neonode began sending sell signals in August. But unlike Men's Warehouse, the share price has not yet shown a substantial correction.
The very strong sell signals are as follows:
First, on August 8th Neonode announced very disappointing second quarter earnings, both compared to last year and compared to expectations for the second quarter.
From the company's press release: "Net revenues for the three and six months ended June 30, 2013 were $1.1 million and $1.6 million, respectively, compared to net revenues for the three and six months ended June 30, 2012 of $2.0 million and $3.1 million, respectively." Not only are the company's revenues dramatically lower than last year and falling, but revenues came in dramatically lower than analyst estimates. Both Cowen and Craig-Hallum also reduced their forward revenue estimates for the rest of 2013.
On August 12th, just a few days after the earnings miss, four different insiders sold a total of over $3 million worth of stock. There also appears to be a large degree of uncertainty regarding next year's revenues. Seeking Alpha Author Tech Guru (who is long the stock) points to an expected revenue of $58 million in 2014 vs. an LTM revenue of just $5.5 million. This means that he expects revenues to increase by ten fold as a result of new contracts. By contrast, author Richard Pearson (who is short the stock) claims that recently announced contract wins are identical to past wins which produced very little revenue. He does not state a specific revenue target, but implies that number will be in line with past results and will therefore not show much of an increase. Not surprisingly, the share price targets proposed by the two authors also shows a wide gulf. Tech Guru is forecasting a $27 share price, up nearly 300%. Pearson is forecasting roughly a $3.50 share price, a decline of 50%.
There are several reasons why Neonode is a "sell" at current levels. We are not incorporating the revenue forecasts from either of the competing authors above in coming to this determination, instead we will leave it to investors to make their own evaluation of these widely diverging expectations.
The first reason is that there have been multiple positive announcements regarding potential contracts in August and September. Each new announcement has seen the stock soar to around $8.00 or above and then retrace to the low $6's. When stocks refuse to hold their gains on good news, it is usually a sign that the valuation is getting maxed out. Like Men's Warehouse, further upside can be elusive while further downside can be quite severe.
The reason why the gains cannot hold is clear. Neonode has never in its history made a profit. Revenues for the last two years were just $6-7 million, but these plunged upon the loss of a major customer in 2012. Revenues have still not recovered. It is hoped that this will begin to change in 2014, however much of that potential success is already priced in following the rise over the past few months.
The second reason is that the stock has remained elevated even despite the onset of several negative developments. This means that they have not been priced in and are giving investors an opportunity to sell and avoid losses which are becoming more probable. The negative news consists of: weak revenues, the earnings miss, repeated insider selling and company selling. Insiders are almost always a better judge of when to sell than are outside investors. Part of the reason that the stock has stayed strong is that the offering by Neonode and the insiders was relatively small. But on the other hand, it is clear that insiders were more than eager to sell at $6.60 and they increased the size of the deal by around 25% from what was originally contemplated. Total proceeds raised in the offering (by Neonode and the insiders) amounted to just under $17 million. This is in addition to the $3 million sold by insiders in August.
In looking at Men's Warehouse, it is clear that most investors saw no need to sell even in the face of numerous clear sell warnings. The stock stayed elevated until a piece of negative news served as the catalyst.
Likewise, Neonode shareholders are currently ignoring several very obvious sell signals even after the stock has risen quickly over the past few months.
Men's Warehouse is a "sell but not short" because it is unlikely to see much more than 10-15% further downside. By contrast Neonode is a "sell and possibly go short". This is because there is the potential for at least 20% downside in the stock as it has far less fundamental cushion than the stable Men's Warehouse. In addition, the fact that good news no longer provides lasting rallies means that it is not overly risky as a short.
BlackBerry (BBRY) - "Hold if you're long, and consider adding long positions"
The previous two examples demonstrate when an investor should push the sell button - even though they may not want to. The last example shows when an investor should refrain even when it is tempting to do so.
It is currently fashionable among shorts to refer to BBRY as a "zero". This is a company which everyone seems to have basically given up on. Many who own it may be tempted to sell due to the overwhelming pessimism. But the downside appears to be mostly accounted for, and the stock is already extremely cheap.
Obviously BlackBerry's business has declined significantly over the last several years, and is continuing to slowly dwindle away, but the company has over half of its almost $5.4 billion market cap in cash and short term investments. Debt is minimal. The company continues to generate over $600 million in operating cash flow each quarter, in line with the $2.6 billion in cash it generated last year.
Selling now is basically capitulating at a time when there is very little more to be lost. The value of BBRY's patents alone will likely make for an attractive buyout scenario within the next 18 months, and there is plenty of evidence to suggest a buyout is a real possibility. This was recently highlighted by Seeking Alpha author George Kesarios in his recent article. Also, the financial community in general has begun to discuss the more and more as recent articles from Bloomberg, the Financial Times, and the Wall Street Journal indicate.
At this point, the short thesis could prove to be painfully incorrect. The stock is likely to be supported by its fundamentals and could prove to be disastrous from the short side in the event of a buyout. Most articles discussing a buyout seem to view this event as increasingly likely.
Despite the powerful rally that we have seen in 2013, it is important to remember that nothing goes up forever. It is also important to remember that usually when a stock suffers from a severe correction, it typically gives plenty of warning signs first.
Men's Warehouse has already declined by 10-15% from its recent multi year highs. But the right way to view this loss is that roughly 50% of the recent gains were surrendered. The real loss to investors was much larger than 10-15%. A recovery in the stock is likely to take several quarters, during which time there is the potential for moderate further downside but little possibility of further upside. However the stock is well supported at some levels by its strong fundamentals and regular dividend. Based on these factors, Men's Warehouse is a "sell if you're long, but do not go short".
Shares of Neonode have given back gains after each of the recent rallies on good news. This indicates that further gains will be very difficult to sustain. Anemic revenues and disappointing earnings signal that the stock may be significantly overvalued following a 33% run up in several months. This is amplified by recent selling by a wide range of insiders at $6.60. Neonode has not shown much of a decline and is still trading above the recent offering price. As a result, Neonode is a "sell if you're long, and consider going short".
Blackberry is a stock which many have simply given up on. But selling due to sheer capitulation is a mistake. Blackberry has a rock solid balance sheet and still generates impressive cash flow despite the decline in its business. From current levels, there is very little downside and there is the potential for very meaningful upside. Despite its very difficult circumstances at present, Blackberry is a "hold if you are long, and consider initiating long positions".
Additional disclosure: I may initiate a long position in BBRY in the next 72 hours.