Unusual bad news can produce share sell-offs presenting the alert investor a low risk opportunity.
Shares that decline to attractive valuation levels warrant an investor's attention.
Some of the best gains are born from some of the worst corporate news.
As many have said, it is a market of stocks, and not necessarily a stock market. While I disagree with this statement to some degree, many individual opportunities in investing arise from one time events, which are not caused by stock market direction. During the early stages of bull markets, the so-called "easy money" stage, where the vast majority of stocks rise, stock selection is not as important as market timing. As equity valuations become rich, opportunities for low risk investing become increasingly difficult to uncover. A watchful and alert investor can often find nuggets of gold surrounded in bad news. Over the last several years, I have bought several issues that have slipped into this scenario, two of which this article will discuss. The first is Walgreen Company (WAG), which fit this bad news scenario after announcing that a pharmaceutical contract with Express Scripts was not going to be renewed. Secondly, when data security issues became nation-wide news at Target Corporation (NYSE:TGT).
In the fall of 2011 Walgreen's announced that due to unfavorable terms, it would not renew a contract with Express Scripts. The Express Scripts contract contributed about $0.21 cents a share to the annual $2.60 earnings per share [EPS] of Walgreen's. Though the estimated hit to earnings was less than 10% of total earnings, the shares however declined 33% into early 2012. The market price declined to a $29 - $34 range as the shares probed for a bottom in price. As value oriented investors began buying shares, the price stabilized in this zone. The chart below boxes the area in which the shares offered good value.
The following chart graphs the historical PE and current yield of Walgreen's since the 1980's. After the decline in share price, the PE fell to the lowest levels since the bear market lows of the early 1980's. The current yield also rose to the highest level since the 1980's. The shares valuation, as measured by these metrics, clearly marked an excellent valuation point for a low risk entry point. The blue arrow marks the low in the PE and the high in current yield.
Had one purchased these shares in this downturn, a gain of over 100% was their eventual reward. I bought shares with an average cost of $30.50 a share, and later sold half my position when it advanced to $60. In short, news that only contributed to a decline of less than 10% in EPS. resulted in a decline in market price of 33%. A unique low risk opportunity was presented to the watchful investor.
A more recent example came from Target Corporation. News broke that security data loss of customers credit card records had occurred sending shares into a steep decline.
The shares that had traded in the low 70's, [A] on the following chart, declined approximately 22% before the decline was arrested at $54 at point[D]. The trading pattern that occurred during this frame is a excellent technical pattern seen quite often. The following bulletins describe this pattern using the chart below.
- Decline begins at [A] at the equity highs in the low 70's.
- Shares decline to [B] with a relief rally up to point [C], completing leg one of the decline [A-B].
- The next decline takes the shares down to the benchmark low marked at [D], completing the second decline leg. At this point the two declines [A-B] and [C-D] are approximately equal in length. Many technical traders will initiate positions at the price where the second leg of decline equals the first. For example, the decline from [A-B] was about 10 points. When the decline from [C] was 10 points orders are executed, in this case at $56 [D].
- The rally to [E] followed by a re-test of the lows at [F] gave one the opportunity to again purchase shares. I bought my second position at this point. I placed two others orders below these levels but they were never executed.
As the shares have not established a upward trend yet, any dips down to the mid $54-57 area [D & F] levels should be viewed as a purchase area.
The current yield on Target shares were above those recorded at the major stock market bottom in 2009. Since the early bottom, the company raised the dividend by 21% from $0.43 to $0.52 a quarter, further increasing the attractiveness of the valuation. It is a common practice for company management to defend shares by increasing dividend payments or by announcing stock buy backs during periods of stress. As illustrated on the chart below, the current yield on the shares are 3.46%, which matches the level recorded after the 1987 market crash.
By no means is buying bad news events a complete investment strategy, but simply another investment arrow in the quiver of investors. In my case, as a both a dividend and growth investor, it is a strategy of seeking low risk entry points for additional equity exposure. The first article that I wrote for SA discussed buying companies that cut their dividend, which is similar in theory to the bad news strategy expressed in this article.
It is the wise investor that watches for singular bad news events that create valuation opportunities. Quite often the market punishes shares well beyond the depth that the bad news warrants, presenting a splendid buying opportunity. One however must weigh the potential consequences of the news to judge whether the effects are a short term shock, or one changing the longer term fundamental factors of the corporation. Investing in quality companies also reduces the risk of long term harmful effects of bad news, as well as selecting points of excellent value.
Disclosure: The author is long WAG, TGT. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.