How to Find Opportunities After a Flood of 20% Decliners Last Week: Part 1

by: Alan Brochstein, CFA

Are markets efficient? This is something the academics in the ivory towers have debated for years, but anyone watching the action this week knows the answer: Not always. In a week of an extreme move down, some stocks appear to have taken it a lot harder than the average stock. While the S&P 500 declined 7.2% and the Russell 2000, the popular benchmark for smaller stocks lost 10.3%, over 6% of the stocks in the Russell 3000 dropped more than 20%.

In a massive sell-off panic, such as we endured (I use the past tense with cautious optimism), dislocations occur. It's impossible to immediately understand and integrate properly all of the information. Some stocks went down because of truly bad news, such as Dendreon (NASDAQ:DNDN), which lost 2/3 of its value. Who knows how much of the selling across the rest of the biotech sector was warranted, but it was a "shoot-first, ask later" environment. It's also difficult to know if someone is selling stock B because they are long stock A which just cratered and they are trying to avoid a margin call, for instance (contagion).

I looked through the Russell 3000, which is a combination of the Russell 1000 (Large-Cap) and the Russell 2000 (Small-Cap) and found that 187 names fell more than 20%. With such a large list, it's difficult to quickly identify overreactions. I was familiar with several of the names (and owned one, unfortunately, in my Top 20 Model Portfolio, though it was our smallest position).

An analytical challenge like sifting through the debris requires a good framework. Here are two approaches. First, many of the stocks that were hammered are in an uptrend but merely correcting. Second, some of the dogs may have been kicked a bit too hard. With this in mind, I created two screens to sort through stocks that lost 1/5 of their value in 5 days. In this article, we will address the "Correction Candidates".

The idea here is that the stocks endured profit-taking, but the fundamentals probably remain intact. To segment this group, I looked for the following:

  • YTD Price > 5%
  • 1 Year Price > 20%

24 names made the cut:

I have sorted the names first by economic sector (8 of the 10 represented, excluding Staples and Utilities) and then by 12-month return. The Energy sector, which was on a roll earlier this year and had bounced back nicely from the June lows only to fall 10% last week (and still up YTD: 0.01%) is overly represented.

I have included some additional information, including forward net debt to capital, PE ratios, earnings growth rates, earnings revisions and short-interest to help the reader hone in on what might be worth pursuing.

With respect to net debt to capital, it might be worth considering the debt position given the potential for the credit crunch to accelerate again. 7 of the names have cash in excess of debt, while several have substantial debt (which I define as greater than 50% of capital). I would be careful with high-debt companies in a potentially challenging capital markets environment.

With respect to short-interest, some of these stocks meteoric runs may have been fueled by short-covering, while some of these that have fallen sharply and have high short-interest ratios could see some covering in coming days. When I see a really high short-interest ratio, it encourages me to understand the bear case better.

Finally, I am very familiar with one company that made the list, and I also want to share my gut feel about a few others. iRobot (NASDAQ:IRBT) is one that I have had my eye on. After they reported the stock ran up, but it collapsed this week. The company has net cash in excess of $4 per share, making the adjusted forward PE less than 20, a remarkable value in my view for an innovative growth company with plenty of ramp ahead. For those not familiar, the company sells robots for consumer applications, primarily vacuuming (Roomba) and has defense applications as well. I think that the latter is what concerns investors potentially, but the reality is that the stock has had a huge, huge run over the past few years that has induced extreme profit-taking.

Some other names that merit a jump to the top of the list for me would include debt-free Gulfport Energy (NASDAQ:GPOR) and perhaps Hercules Offshore (NASDAQ:HERO), which is in the middle of a big merger that should improve industry conditions. Ariad Pharma (NASDAQ:ARIA) may have been a victim of the DNDN fiasco. The same might be said for Valeant (NYSE:VRX), which is the largest company (market-cap) on the list. W.R. Grace (NYSE:GRA) sure looks interesting too. It has over $10 per share in cash net of debt (though it is burdened with several LT liabilities, including asbestos and other issues related to its bankruptcy from which it emerged in 2004).

So, several of the stocks that plunged last week remain up YTD and seemingly in bull trends. The above list is certainly not a guarantee of continued success despite the stumble, but there may be some opportunities. In part 2, we will take a look at some of the really beaten up names that might appeal to a more value-oriented investor.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.