Another great way to find potential investment ideas are to look for gap downs and news events. A gap down is when a stock opens up significantly lower based on news that occurred after the market closed the business day before OR before the market opens back up. Here is a recent example of a gap down from Under Armour:
As you can see, on Oct. 24th, towards the middle of the chart, UAA dropped significantly. This is a perfect example of a Gap Down.
A gap down could occur for several reasons. Some are terrible, which we need to be aware of, and others are just overreactions to news that isn’t as bad as expected. This is where we can find some gems. Examples of terrible news events are fraud by the executives such as the case with Lumber Liquidators, accounting fraud such as with American Realty Capital, earnings surprise due to a company’s products becoming obsolete, etc.
Here are a few examples of bad news that wasn’t terrible, but created a great buying opportunity: Under Armour is down 26% year to date as of 12/8/16. The gap down in the chart below is due to their sales growth forecast being lowered from the high 20’s (average about 28%) to the low 20’s going forward. We shall see how this plays out, but I love UAA, the CEO, the products, the financials of the company, and this to me looks like an overreaction to news that won’t kill the company. I bought in at 31, I sold puts at 27.50 and if it continues to slide, I will continue to buy more.
Another example was Target’s data breach a few years back. At the time it happened, a few other major companies had similar issues. The news sounds bad, but with the other companies, they spent some money to provide identity theft protection for the people who were affected by it, but that was the worst of it. I didn’t think that issue, although a very bad PR issue would devastate the company. At the time Target was on my watch list, but it was never cheap enough to buy from a valuation standpoint. I loved the shopping experience there, especially compared to Walmart. The stores are always clean, they always have a ton of registers open, unlike WMT, and it’s a stress free shopping experience for someone like myself who hates to shop. The data breach caused the stock to fall from the high 60’s to a low of $50 in Jan of 2014. This seemed like an opportunity to get into a great company at a discount. The stock traded flat most of the year, but by the first quarter of 2015 it had risen to approx. $80. We got out at $78 making a great return on a great company. We sold because TGT was valued higher than any previous time in about 8 years. As of today, almost 2 years later, it is still below the price where we sold it.
Here is a 1 year chart on Manpower:
In the middle of the chart, June 2016, is when the Brexit occurred. That created a lot of uncertainty especially for companies who did a lot of business in Europe. 65% of MAN’s revenue came from Europe. As you can imagine, this created a lot of fear and uncertainty causing the stock to fall from $85 earlier in the year to a low below $60. I didn’t follow MAN when this occurred, but I started to read about it after the Brexit. Unfortunately for me, the stock had already rebounded to $70. However, the stock at that price was still very undervalued. The Brexit did not cause the underlying fundamentals of the business to change, it wasn’t going to cause them to go bankrupt, there were no lawsuits because of this…it was just a major overreaction, or as I like to call it, a major buying opportunity. As of today, this buying opportunity did very well for me. My price target calculations were between $85 – $95 conservatively. Today it’s at 88.90, which gives me a rate of return on investment of 27% in just 6 months not including dividends or options premiums collected to lower my basis!
Some ways to find these ideas would be to look at the 52 week low list on WSJ.com or Morningstar.com. This is part of their free service, also look at their daily biggest decliners, read or watch the news. Another resource is Value Line. They have a list of the out of favor sectors. Find the best companies on that list. A beaten up sector doesn’t stay down forever. It may seem strange that we are looking for things that have bad news and are big decliners, but as a value investor, we are looking for companies that are currently out of favor in the short term. This is what causes a great company to go on sale. Remember what Warren Buffet says: First, most of the time a stock will revert back to their mean. So, if a stock is overvalued, it will come back down, but also, if a good stock is very undervalued, it will go up to where it should be valued. This is what we are looking for. A good company that is on sale, and then we wait for it to revert back to the mean. He says Most of the time they will revert back to the mean, not all the time. That is because there are times that a company is out of favor because of bad news that is really bad and it can’t recover from that. We need to be able to differentiate between the two. A little research and a little common sense will help us do that. The other Warren Buffet quote, be Fearful when others are greedy and be greedy when others are fearful. Most people aren’t good investors and they get afraid and sell when there is bad news. We want to take advantage of these times when the market misprices a stock because the majority of investors are selling. This creates the opportunities we are looking for.