Finding a Trade Candidate 1
This is going to be a four part series. There are about 15 or 20 criteria to look at when you’re looking at a possible trade candidate. In this series I will try to explain to you what I am looking at and how important each aspect is in determining if you have a trade and how strong or weak of a trade you are looking at. I much prefer a stock that is down 75 to 90 percent from the highs. With these if you’re not looking at a value trap it’s hard to lose money if you have done a good job on your due diligence.
The price / earnings ratio (P/E) is an objective valuation of the stock/equity that you are looking at. P/E and a drop from the highs of 40 percent or more are the two most important things I am looking for in a trading candidate. I much prefer a stock that is down 75 to 90 percent from the highs. With these if you’re not looking at a value trap it is hard to lose money if you’re patient and prudent when you enter the trade.
Growth and future earnings are the most important factors in the proper evaluation of a stock.
The first thing I look at is the past two years earnings and revenue growth. These I get from Briefing.com and/or Tradestation. Whatever broker your with should provide you with a wealth of information on the stocks your interested in. Next I go to NASDAQ.Com and check the next two or three years projected earnings. Bear in mind that on stocks that have been falling for a few months to several years the projected earnings are probably as accurate as they ever will be but on a stock that just crashed on bad news that may not be the case. In that case you have to make the necessary adjustments. Theses may not be to the penny but should be as close as the available information reflects. If you can’t do that or are not comfortable with the analysis you have reached, don’t trade.
I recently looked at a new trade that had guided down by 40 cents for the next quarter and said the following quarter would be weaker than projected but only slightly so. Their next year’s earnings were projected to be $3.10. I took 60 cents off their next year’s earnings (20 cents off their only slightly weaker quarter) and felt that if I had made a mistake here, it was to the safe side. I based my future earnings analysis on next year earnings of $2.50 per share. If it comes in at $2.60/2.65 I’m all to the good.
Never forget that the stock markets are a discount mechanism for the future, normally six months to one year in advance. The past is history and as such only has a small relevance to future stock prices. Also, a statement by a company that they missed their quarter because a large customer, or even several small customers moved their orders back a few days or weeks and those orders will come in the next quarter are meaningless. That slowdown in orders may continue indefinitely. I don’t base a trade on supposition by a company who is trying to maintain their stock price.
Let’s take a look at one of my wilder trades. On March 14, 2016 VRX lower their quarterly guidance from $2.62 to $2.50. Previously VRX had disclosed an unknown relationship with Philodor, a drug distributor that the company used. Because there were several problems manifesting in a series investor confidence in VRX had falling sharply.
VRX had closed the previous day at $69.03 and dropped to $33.01 the next day. I traded in the middle of that and lost money. Fortunately it was a small position.
The charts below show the result.
Valeant Pharma Ad Hoc Committee says review of various Philidor and related accounting matters is complete, has not identified any additional items that would require restatements (26.11)
The co announced that the ad hoc committee of the board of directors (the “Ad Hoc Committee”) believes that its review of various Philidor and related accounting matters is complete, and that it has not identified any additional items that would require restatements beyond those required by matters previously disclosed. Given the completion of the review, Valeant’s Board has determined to dissolve the Ad Hoc Committee and that the 12 independent directors on Valeant’s Board, including the members of the Board’s Audit and Risk Committee, will assume oversight responsibility for remaining work associated with the completion of the Company’s current and restated financial statements and disclosures, as well as its assessment of related internal controls and remediation matters. As previously disclosed, the company intends to file its Form 10-K on or before April 29, 2016.
- “We appreciate the efforts of the Ad Hoc Committee and its independent advisors over the past five months. After conducting more than 70 interviews and reviewing over one million documents, the Ad Hoc Committee has not identified any additional items requiring restatements beyond those matters previously disclosed. We believe it is appropriate to transfer responsibility for any continuing work to the Board’s independent directors. We continue to work diligently and are on schedule to file our Form 10-K on or before April 29, 2016.”
- The company is in the process of restating the affected financial statements and the restated financial statements will be included in the company’s Form 10-K for the year ended December 31, 2015, which the company intends to file with the Securities and Exchange Commission and the Canadian Securities Regulators on or before April 29, 2016. The company believes that after giving effect to the restatement, it will have remained in compliance with all of the financial maintenance covenants in its credit facility at the end of each affected quarterly period.
- Courtesy of Briefing.com
I felt that VRX was a buy but was unwilling to buy until they showed some news or chart pattern that indicated they could and would move higher.
The 120 minute chart above includes pre-market trading. As you can see above the news was posted at 7:48 Eastern Time and the market doesn’t open until 8:30. VRX opened at $29.60 and ran up to $38.18 in the next few days.
You have to have a strategy and be flexible on trades like this. I normally determine value and then just hang in there but the news on 3/15/2016 was very bad when combined with their previous bad news. Investors, including myself, had no idea what else may be lurking in the wings. Now I’m in VRX at $26.44 and expect it to go to $53.00 to $70.00 at the least. With some new management and a little good news maybe even back to $100 plus.
When I bought this the P/E was 2.73, by far the lowest P/E I have ever purchased. Sector P/E is 19.
Now let’s look at a trade I do all the time.
Rent-A-Center beats by $0.02, misses on revs (13.28 -0.34)
- Reports Q4 (Dec) earnings of $0.54 per share, excluding non-recurring items, $0.02 better than the Capital IQ Consensus of $0.52; revenues fell 0.4% year/year to $793.8 mln vs the $806.33 mln Capital IQ Consensus and same store sales +1.7%
- The Co expects to deliver growth in earnings per share assuming:
- Core U.S. revenue down 4.0% to 6.0% driven by same store sales decline of 1.0% to 3.0% and the impact of store rationalization efforts
- Acceptance Now revenue of $850-900 million
- The Co expects to deliver improved operating profit margin, EBITDA, and free cash flow in both the Core U.S. and Acceptance Now
- Courtesy of Briefing.com
One of the problems I still have as a trader is finding it hard to understand how everyone else doesn’t see the same opportunities I do.
When you remove the overhang and earnings are over 2 bucks a share where else can RCII go but up??? The only comments I saw on RCII after their earnings call were negative, some even saying it would/could go to seven or eight
Rent-A-Center, Inc. Goes on Sale
Rent-A-Center, through rent to purchase agreement, sells name brand appliances, furniture, electronics, particularly cell phones, computers and other durable goods to consumers.
These consumers tend to be low to middle income with low credit scores. With the way the real economy is trending, we may see a lot more RCII customers soon.
On Feb. 1, after the market closed, RCII reported their fourth quarter earnings of $0.54, a 2 cent beat over Capital IQ consensus of $0.52. Revenue fell year over year by 4 % to $793.8 million versus $806.33 Capital IQ consensus.
RCII also incurred a $1.17 billion goodwill impairment charge that reduces their GAAP earnings to a $17.20 per share loss. Wow, what an opportunity.
A goodwill write-off involves no money. The company has incurred no new monetary loss. The number freaks out investors, but doesn’t change the profitability of the company.
FY17 earnings are estimated to come in at $2.04. At this writing (2/9/2016), RCII closed at $11.13 with a forward P/E of 5.4. XRT, the retail ETF, has a P/E of 16 currently. Although I don’t expect RCII to return to the 30’s anytime soon, I do expect it to hit $17 within 6 months and $25.00 within two years.
I know many traders and investors shy away from stocks with horrible news and the attending reaction in the stock price.
As we all know, this impending goodwill impairment has been hanging over RCII for some time now. Now it has no impending bad news overhang. Since the overhang is gone and didn’t change their sales or cash position, there is nowhere for RCII to go but up.
From the large red bar on the right of the screen shot that bottomed around $17.50 RCII fell in a huge slide from $26.00 to $10.00 in four months. Just the huge slide is enough to qualify RCII as a trade candidate.
I first bought this at $17.05 but it only bounced to $19.13 before falling back to 17 in a few days. I was stopped out there because it didn’t show enough strength to get back to $26.00, which was my target. The bounce off $9.76 on the daily chart above is what a bounce off strong support should look like.
A sector P/E of 16 and forward earnings of over $2.00 tells me RCII will return to the 30’s now that the goodwill overhang is gone.
In the piece I wrote on 2/9/2016 I predicted $17 in six months and $25 in two years. If you look at the weekly chart above you will see where those targets came from.
NASDAQ.com earnings for 2017 are projected to be $2.01, 2018 at $2.92 and 2019 at 3.42. When it gets back to a 16 P/E in 2019 the RCII will be at $55.00 per share. To find this information go to NASDAQ.com, type in the symbol of the stock your interested in, go to analyst research and then to forecast.
Growth in 2018 will be 31 percent if all these projections are accurate. If they are then RCII’s P/E should move into the 30/35 area and the share price would be in the $95/$105 area. On a retail stock (and most other categories of established companies as well) the P/E should be around its current growth rate.
In the SPY chart above I circled the date that RCII reported. Spy continued lower for a week and a half while RCII moved higher after the panic selling was over.
XRT is the retail ETF that I use. There are numerous sources to check which stocks make up this of retailers. Even if your stock is not listed if it’s a retail stock this is the ETF to watch.
RCII is listed as a rental agency like United Rentals,Inc. (URI) but is a rent to own retail store. Use your head. If you’re going to beat the market you can’t follow the herd.
The rule I go by with growth rates is if growth is falling 5/10 percent I will not buy over a P/E of 5 and then only if I can see stabilization in sales within six months. If sales are dropping faster than that I stay out until I see stabilization. If sales are flat to 2/3 percent up I’m looking for an entry around a 6 P/E. If sales are growing 5 to 10 percent then a 7 P/E will work.
Don’t forget there are many variables to this P/E guideline. Is the market rising? Is the sector rising? Is the company’s product still viable? Remember Kodak? What is the sector P/E? Has the company had a series of bad news events? Is management the problem? These are but a few of the variables that will affect your trade. Buyer beware.
You are the arbiter that determines whether to believe these numbers or not. I personally will sell half my position at $17.00 and half of that again at $26.00. I will let the final quarter ride depending on the company and economy at that time. You will need to periodically (every news or earnings event) reevaluate your position in every stock you hold.
The other important consideration at the point of purchase is whether or not this is a value trap. A value trap is a stock that can’t recover from a decline because of a basic flaw in the structure of the company. It could be like Kodak. When digital photography came along Kodak didn’t change their business model to embrace the new technology. When did you last buy film to take a picture? It could be poor management, massive debt that they can’t service and survive or any number of other things although those three would be the most likely choices. Your job is to check and be sure there is no fatal flaw in your investment. Many trade opportunities I look at have no earnings and I can see no prospect of a turnaround. No earnings means no value. Move on , there are hundreds of other opportunities for value buys every year.
For and index you can use the DIA, SPY or the QQQ’s, whichever one is more appropriate for the stock you are working with.
To find the sector the stock is in go to Yahoo, enter your stock symbol and then click Industry in the left hand column.