Picking Stocks When It Looks Like The Fix Is In

by: Adam Levine-Weinberg

In a very interesting article from earlier this month, fellow Seeking Alpha contributor Rocco Pendola claims that many investors hold their favorite stocks as they plummet, in spite of believing that their woes are due to market manipulation. "If you think unsavory groups are manipulating a stock, why on earth would you stay long? Most answers to this query stink of emotional attachment," he writes.

Rocco makes a good point. As an investor, you may be convinced that a higher share price is justified by a company's fundamentals, but as the old saw goes, "the market can stay irrational longer than you can stay solvent."

Basically, some stocks trade like the fix is in. Investors have already determined that the stock is "good" or "bad" and the market seems impervious to contrary information. That said, I am not a big believer in the bogey of market manipulation. By and large, when stocks trade like the fix is in, it's because analysts/investors are suffering from confirmation bias and thus tend to filter out data that would contradict their original beliefs. If this is the case, a patient investor can make a healthy profit by opening a contrarian position and waiting for sufficient unambiguous contrary data to appear. If your investment thesis is correct, this will happen eventually, and you will make a killing.

(Example: On May 31, I opened a short position in NFLX at 270. The numbers didn't make sense and the valuation was out of control. The stock quickly fell to $245 but then rocketed above $300 on vague news about global expansion and the possibility of new content deals. The stock then shook off very ho-hum Q2 earnings in July. In early August, I bailed out at $248 a share because I was convinced that the fix was in. Investors didn't seem to care how bad the news was and would bid NFLX up regardless. Had I stuck with my conviction and held on a few more months, I could have turned my 8% profit into a 75-80% profit. As Rick Perry would say, "Oops!")

The trick, then, is identifying catalysts that are likely to bring gains in your position to meet your investment goals over your personal investing time horizon. Here are a few stocks in my portfolio that trade at unreasonable valuations, along with the catalysts that I expect will take them to more reasonable prices.

Long Ideas

1. United Continental (NYSE:UAL): Most value investors love to dump on airlines. But as I pointed out earlier this month, the company is worth nearly double its recent price. Falling oil prices and shrinking capacity are finally allowing the leading airlines (like UAL) to fully offset year-over-year fuel price increases with revenue increases. In their worries over sovereign debt, investors seem to have missed the significant drop in jet fuel prices over the past few weeks. I expect to see gains over the next six months due to several catalysts: 1) Turning in a profitable fall/winter so that investors will be able to look forward to the seasonally stronger spring and summer quarters; 2) easier comp. numbers in the spring on the cost side, due to this year's Arab Spring oil shock; and 3) reducing the "merger overhang" as the airline hopefully makes progress on integrating the two carriers.

2. Research in Motion (RIMM): This is another absurdly beaten down stock. Sure, the company might be better off being run by the Muppets than by the current management team, but the fact remains that the RIM services business is a cash cow. Investors have spent so much time lamenting how the Blackberry has lost its dominant position in the smart phone market that they tend to overlook how the product still has a niche that will not disappear overnight. This is a longer-term play, though. Investor sentiment is so negative that it could take as long as 2-3 years of RIM remaining profitable before investors will admit that the company is not dead. Only a string of profitable quarters that meet forecasts will allow investors to regain their confidence in RIM. When that happens, though, the stock will pop back to the $30-$50 range (or even higher, depending on the company's performance in the interval).

3. Nvidia (NASDAQ:NVDA): As I wrote last week, I think that investors may finally be warming up to NVIDIA again. While the valuation for NVIDIA is not nearly as depressed as for the previous two stocks, the company has significant growth prospects that can be bought essentially for free. Investor relations missteps over the past two or three quarters have led to a situation where some analysts worry that the company's Tegra chip has run out of gas, even though it will bring in $400-$500 million in revenue this year (up from essentially nil last year) and $1 billion next year, if management projections are accurate. All the company needs to do to get the stock back to $20 is meet its guidance for Q4 and provide a Q1 revenue forecast consistent with management's claims about substantial Tegra 3 smart phone design wins. I expect this to happen, and am holding my position.

Short Idea

J.C. Penney (NYSE:JCP): A few weeks ago, I laid out in detail why J.C. Penney is a disaster waiting to happen. The stock has fallen somewhat since then, but still has a long way to go before it reaches fair value. Over the past 15 months, J.C. Penney stock has been sustained by one fantasy after another. First it was the idea that Bill Ackman was going to bring major changes to "create value." That was enough to double the stock price in six months, but the effect wore off amid weak sales numbers this spring and summer. Then the company appointed Ron Johnson (of Apple Store fame) as its new CEO, which resulted in a one day stock gain of over 15%. More recently, there have been smaller bounces as Johnson assembled a new leadership team. But none of that changes the fact that sales and profit numbers for the past eight months have been atrocious. If the old management team had been vastly incompetent, then there might be substantial improvement on the horizon, but J.C. Penney's problems are structural. Its core customers will never again spend like they did in the credit-happy pre-2008 period. In the next three months, this stock will likely plunge to $25 or less as sales and profit continue to disappoint even in the traditionally profitable holiday season. Each month provides a sales report that can act as a negative catalyst for JCP.

Disclosure: I am long UAL, RIMM, NVDA.

Additional disclosure: I am short JCP.

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