This is Part 2 of the series, which started with Tuesday’s article, "Identifying Stocks That Are Poised to Triple Part 1." In this article I will provide the actual Risk & Reward charts that I use to trade one of my favorite "stocks that are poised to triple".
In the last article, I provided an example of how to build a bullish Risk & Reward chart, using Pandora (P) as an example. Of course, many investors are actually bearish on Pandora. The polarizing nature of this company accentuates the need to utilize Risk & Reward charts.
If you believe Pandora's shares are overvalued, your Risk & Reward chart might look like this:
(Click to enlarge)
This chart depicts how Pandora’s shares might decline to $6.75 or less by the end of 2012. As described in Part 1 of this article, paying attention to the upper and lower boundaries can help to greatly increase your returns. In this case, if Pandora simply glides down along the lower trend line, an investor stands to benefit from a 53% annualized slide in the shares. However, shorting the stock at the upper end of the range provides a much more attractive 67% annualized decline.
Of equal importance, shorting at the top end of your pre-defined range minimizes the risk that Pandora’s shares will go significantly higher. At the low end of the range, a string of positive news flow could spark a short squeeze. At the top of the range a similar string of good news will usually be largely dismissed as “baked into the stock".
Next, let’s examine the Risk & Reward chart for one of the cheapest plays on the online music revolution, RealNetworks (RNWK):
(Click to enlarge)
In a bear market, relying on intrinsic value is not enough. Investors should seek the safety of underlying assets, along with a management team that is willing and able to make tough decisions to attain or maintain profitability.
RNWK fits the bill perfectly. The company is selling for close to book value and hovers around break-even. This limits investors’ risk. Meanwhile, management is actively making moves to boost profitability and unlock shareholder value. As part of that plan, the company will be issuing a $1 special dividend next week.
The company also owns nearly 47% of Rhapsody. This is an undervalued asset, valued at $11M on RNWK’s balance sheet, but likely worth several times that figure. It is one of only six companies in the world holding on-demand licenses with the major record labels. As Facebook Music rolls out, these licenses will skyrocket in value due to their unique ability to enable social music sharing. Over time, this stock is clearly poised to triple.
At present, Wall Street analysts believe that RNWK’s current breakup value is somewhere between $5 and $7. Looking further out, I believe the shares could reach $8 by the end of next year. That price target enables us to form the top trend line our Risk & Reward chart above. As usual, the bottom trend line runs parallel to the top trend line, while the dashed line sit halfway between the two (since it represents the midpoint of risk and reward at any given time).
Take note of the fact that my 2012 price target was derived through fundamental analysis. Yet, when I plot a future path for RNWK to get there, it fits perfectly with the stock’s historical technical pattern. This is how and why fundamental analysis can enable us to predict technicals in advance.
The other important thing to note is that RNWK’s trend lines only move at a rate of 16% per year. In other words, if you buy and sell the stock when it’s at the top of its range, your annualized return will be limited to 16%. That’s a decent return, but that won’t make you rich. However, if we buy the shares at the bottom of its range (which is where they are at present), the ride to the top trend line will generate a 100% annual return!
The best thing about this is that the company is selling near its book value and well below its break-up value. In other words, we don’t have to worry if the stock market crashes -- our risk is cushioned by RNWK’s large base of assets. Thus, our high potential for reward comes with very little risk. Owning a basket of similarly attractive risk/reward plays will make you rich with little risk to your hard-earned saving.
If you are armed with the right fundamental analysis and a risk/reward chart, you’ll be piling in while frightened investors are panicking out…and taking huge profits while over-excited investors chase the shares at their peak.
Disclosure: I am long P, RNWK.
