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Estimating the potential for a major gap down is a critical part of any risk management plan with the key question being: What is the risk that the stock could gap far beyond my stop loss point? I am frequently wrong in my thesis about how the market will price a stock over time, however the key is to minimize losses in these cases and avoiding catastrophic gaps is a major part of this process. A risk reward scenario is only valid if the risk can be contained, and the potential for a large gap down is one of the major challenges for any risk assessment. Gaps also offer significant opportunities since they often are revealed to be major overreactions magnified by the self-reinforcing selling triggered by negative news.

Before I discuss some strategies for avoiding the next melt-down, where do we go from here with Best Buy (NYSE:BBY)? Is this a value-based buying opportunity or a reversion to the downtrend of 2012?

In short, I believe this might present a trading opportunity based on the thesis that there will be reflexive buying from people who missed last year's move and who have a bullish view, however I don't believe this represents a strong value-based entry point for the followings reasons:

  • I question whether a business with virtually no moat, and numerous strong, thin-margin competitors can be considered a candidate for a value investment at all
  • Best Buy has a lot of under-monetized real-estate. So does Sears, and JCP. This effectively creates a lot of retail "shadow-inventory" which multiple payers will be competing to find tenants for. Best Buy appears to be doing the best job so far of creatively addressing this problem/opportunity. The key question however is whether this is a business model that deserves a high-conviction position for your long-term capital and I would argue that the closest analogy for this business model are the retail REIT real-estate operators. While these are certainly viable long-term business models, they are hardly the growth engines that Best Buy's return over the past year would imply.
  • It is important to remember that the store-within-a-store concept is also subject to the show-rooming risk, even though it may be a reduced risk due to the service-intensive nature of the tenants.
  • My view of the latest holiday sales report is that it actually reiterates the bearish trajectory of the core business model (sales actually fell year-over-year even with all the improvement made over the past year) and a significant rebound from the recent sell-off is more likely to be a shorting opportunity rather than a return to long-term growth in the value of the business.

The more important question in my mind however is: What can investors learn from this to minimize the risk of being caught in another major gap-down in other stocks. While this risk can never be avoided completely, I focus extensively on avoiding this type of risk as part of my own investing and I use the following general guidelines to try to minimize the risk, or better yet, benefit from gaps higher. Best Buy is a great example of many of the factors that go into both sides of this analysis and here is an overview of the guidelines I have used to attempt to minimize gap risk and profit from it where possible.

Know and Monitor Key Gap Event Triggers

As obvious as it may sound, carefully assessing each of your current positions,as well as any new positions, in relation to key events which could trigger a gap is critical to risk control. Earnings are the primary gap-trigger for most companies however industry-specific reports can often be even more important, such as drug trial updates in the pharmaceuticals industry, production reports in the energy industry and sales reports in the retail industry. Major pending legal rulings are also critical to monitor. For this reason, I take most of my new positions immediately after a key gap trigger has passed and review all my positions as a gap approaches to assess based on the list below whether the risk of holding through the potential gap is justified, and what degree of hedging may be justified. Other events like pre-announcements and analyst rating changes can also trigger a gap, however since the timing of these is less predictable, they fall under the general risk drivers in the guidelines below.

In the case of Best Buy and most retailers, the post-holiday sales and earnings reports are arguably the most important Gap triggers of the year. I exited my Best Buy long position (which was via short-puts for even greater gap protection) in mid-December on the thesis that any remaining upside was far outweighed by the potential for a large gap down. So far, so good. A much better move in retrospect might have been to pick up some out-of-the money January puts as well, although in general I find options near gap triggers to be overpriced and I did not have strong conviction that a negative report was in the works. The most important takeaway however is that risk control comes first and every investor needs to be aware of the timing of gap triggers, and hedge or update positions accordingly. I use the guidelines below as a guide to determine the risk presented by these triggers.

Is the stock priced for perfection?

A more precise statement would be, is the stock priced as though events which are far from assured have already happened, and what is the true value of the business if some or all of these events don't happen? This is a very common situation in the pharmaceutical industry when drugs in the development stage are often priced to discount approval of the drug and the capture of significant market share. The major problem for risk control in these cases is that the floor of true value based on current value in the business is usually far below the price of the stock. Even worse, the time required for the stock price to recover to its pre-gap-down level gives competitors plenty of time to respond, so simply waiting longer for the bull case to play out is not necessarily a reliable strategy.

In the case of Best Buy, it is by no means clear that the trajectory of the total business is even positive, let alone sufficiently positive to justify the levels reached in early November. It is certainly less negative that it was in late 2012, however positives like the gain in the on-line business and better use of the physical footprint don't necessarily create a business which can compete successfully. It may rather create a business that declines less slowly or grows at a painfully slow and inherently limited pace.

Where would value players likely find value? Conversely, how much of the stock price has been driven by momentum players?

When I develop a risk model, one of the first questions I ask is where value-oriented investors are likely to add to positions on a sell-off? While there is no ideal answer to this question, a way that I have found to be fairly reliable is to track back to the last price point where a major positive value-indicator occurred, and then assume that approximately 75% of any move since that point was driven by price-momentum investors. This gives a rough idea where there may be value investors who missed the previous move waiting to enter if a major downturn occurs. It also gives a rough idea how long the stock has been moving purely on momentum and therefore when it there will be a lot of investors with tight stop-losses who will all pile out of the stock in the event of a break in the uptrend.

In the case of Best Buy, I would assign this to the gap up from the earnings in mid-August which occurred from approximately 30 so and implies that at the current level around 27 there is good potential for a short-term rebound into the low 30s . This is actually generous since it is unclear if the business was actually competing successfully or just less badly at the time of the August earning, however what it says is that the potential size of a gap down from the price in the 40's was enough to require very significant upside to justify exposure to the risk of a gap down going into the sales report.

To gain greater perspective on whether this is a long-term buying opportunity in Best Buy, it is instructive to use this approach to compare Best Buy to another gap victim and that is Cameron International (NYSE:CAM). Cameron dropped from 63 to 53 after its earnings release in November due to a lowered growth outlook. Comparing CAM to BBY we find several key differences. CAM is in a business (oil-field services) with a clear degree of distinctive competence that would be difficult for a competitor to duplicate. CAM is clearly growing and currently profitable in an industry that has one of the most consistent sources of growing demand (petroleum extraction technology) anywhere. The trigger for the gap down in CAM was a slowing of growth, not an outright decline in its core business model as Best Buy has experienced. For these reasons, CAM was a great example of the type of sell-off that presents both a short-term trading opportunity and a true value entry point, while for Best Buy I believe it likely represents a re-validation of the long-term bear case. While CAM was likely ahead of itself in the mid 60's, a 20% decline reduced much of the risk in the stock, however even with the sell-off in Best Buy, it is not clear that the business trajectory is actually positive.

Does the stock have a history of major gaps?

Stocks and businesses have personalities, and a meaningful degree of risk can be estimated by studying the history of a particular stock and it's peers. For example, Cree, Coach, and Cisco are three serial gap offenders, and a quick look at their long-term charts will alert an investor to higher than normal risk. Conversely, a lack of major gaps, especially at earnings announcements, is a sign of reduced risk. Also, it is important to recognize when an asset trades with gaps larger than the daily trading range. This is often the case for ETFs which are based on another asset that largely trades outside of the US equity market hours, like commodities, currencies and precious metals. This does not mean to completely avoid these vehicles, but rather to take the trading characteristics into account in any risk/reward model.

The recent history of BBY would have suggested moderate-to-high risk since the stock had generally positive gaps last year with the exception of a significant gap down in November which was a significant warning sign that any under-performance would be met with major selling. At the time I felt the gap was overdone and presented a tactical long opportunity through the sale of out-of-the-money puts with a stop based slightly below the low of the move after the gap down. This turned out to be a profitable trade, however it was also a sign that it would be very risky to hold a long position through any gap trigger events.

Factor Gap Risk Into Your Method of Investing and Hedging

Since the outcome of the criteria above will rarely be a yes/no assessment but more likely a general estimate of gap risk, there are a number of ways to consider moderating risk through investment method. If I think the risk of an unrecoverable gap is significant, I will almost always sell completely out of the equity and potentially add some form of short position. If I want to stay long for some reason and I think the risk of a gap down is low, but still meaningful, examples of hedging methods I may use include:

  • Selling out-of-the-money calls
  • Replacing part of a long-equity positing with the sale of out-of-the-money puts
  • Dividing positions between similar equities
  • Buying short-term puts
  • Converting a long-equity position into a smaller long-call position to limit downside risk while maintaining upside exposure

If you think that the risk of an unexpected gap down is meaningful but you still want to be long the equity, selling out-of-the-money puts may be a better approach than being long the equity, however timing is key to avoid trigger events and it is critical to close the position before a trigger event, since you would otherwise be exposed to low gain and high risk. For example, someone who sold the January 33 puts after the November gap down would have, as of Wednesday, January 15th, captured a nice profit with only a small percentage remaining in additional potential profit, however that same profit would now be a major loss after the following gap down.

Taking all this into account, the plays on Best Buy I will be watching for at this point are:

  • Selling the out-of -the-money puts as a way of capturing a sideways move or short-term uptrend in the time between now and the next earning release in late February. At this point I don't see the reward necessary to offset the risk of being long through the earnings release.
  • Looking to initiate a short position assuming a near-term bounce occurs, again after the earnings release, and assuming no new fundamental news appears to change my negative bias.
Source: Mind The Gap: Lessons And Opportunities From The Best Buy Meltdown