Archive for October, 2010

Find the Value

I like to buy good companies that have just come out with bad news and are under extreme pressure. I like to see these types of stocks trade down hard on the news….20%, 30% 40% in a matter of days or a week or so.  

The sell off gives investors an increasingly rare opportunity to buy value at a discounted price. The reason that it is an increasingly rare opportunity is due to the evolution of the markets led by technology and globalization.

Today, there are more market participants than ever before thanks to the globalization of the markets. In addition those participants are up to date and versed on all of the current data thanks to the internet! This leads not only to more liquid markets but also to more accurately priced stocks. So, today, it is harder and harder for people to find undervalued stocks due to the increased accuracy of value.  One of the few times that one will see an opportunity to grab a stock at a discounted value has to be during a time of irrationality. With all of the additional information available there is more chance for smart, rational decision making and valuation.

Therefore, it will take something more than “regular” bad news to cause a moment of fear leading to irrational and illogical decision making. That decision making process will be governed by emotion instead of logic. And since this will occur less frequently, due to better information and increased participation, it is going to take a significant degree of bad news to create the panic necessary to lead to irrational selling. However, with irrational selling comes an opportunity to buy a stock at a price that is discounted to value. Easy enough, right?

After the bad news comes out there are a couple of factors that come into play. First, how do we know the difference between really bad news and deadly news? Think about it, how do we determine the difference between the bad news Transocean (RIG) received and the bad news Bear Stearns received? Well, unfortunately, there is no specific rule or guideline to tell us the difference between a severe wound and a mortal wound. So judgment becomes a critical factor in the decision making process.

Since judgment is so important in identifying the difference between a golden opportunity and a land mine, the cardinal rule must be that if you are not sure, then, pass on the trade. Realize that some opportunities are very risky trades and not for everyone. The reason a stock might lose substantial value so quickly is that the news that was released was bad enough to make the vast majority of investors and traders out there either sell or at least move away from buying it! By stepping in and making a purchase against the heavy market sentiment of the time, you are going against the prevailing school of thought. You are saying that the market and all of the intelligent people in it are wrong and you are right! It takes a lot of confidence, maybe bordering on cockiness, to make this trade. In order to make that trade, there must be skill involved when it comes to dissecting the news.

I wish there was a black and white rule, but there is none. Common sense and logic will hopefully aid you in this decision making process as you go against the market.

Once the determination on the seriousness of the news has been made and the decision to buy has been set, the next factor is determining when to jump in. This can be as difficult and treacherous as deciding on the severity of the news. If you jump in too early, you may have to handle a considerable amount of pain before the stock finally bottoms out. For many, this could be too much pain to bear! If you hop in too late, you may find yourself chasing the stock as it bounces up as quickly as it traded down and you miss the greater part of the discounted value that you were seeking to capture in the first place.

The bright part here is that there is an answer to this dilemma. The answer is a good working knowledge of Technical Analysis especially in the area of support and resistance. With the use of historic support levels combined with a scaling in buying strategy, the odds of you getting in at the right time and price level is greatly increased….but not assured. As you know in the markets, there is no guarantee. Successful investors know this and thus play the odds by hopefully putting the odds in their favor. That is exactly what the ability to locate support points using technical analysis does and why it is so important!   

Trying to find value in this market is not all that hard as long as you want to pay for it. However, trying to find discounted value in any market is much more difficult and much riskier. With this increased risk, an investor would be well advised to learn how to use options to both hedge a stock position or better yet to replace the stock position with a stock replacement option!