Be on the lookout for bad-news bargains

As earnings season approaches, some companies may lower expectations, leading to drastic but often short-lived sell-offs. Here's what to watch for.

By StreetAuthority Jun 24, 2013 3:07PM
 Poster proclaiming Sale up to 50% off and shoppers silhouetted in foreground copyright Michele Constantini/PhotoAlto Agency RF/Getty ImagesBy David Sterman

As we head into the final week of the quarter, expect a fair number of companies to lower their guidance. And though it may seem counter-intuitive, get ready to put some cash to work.

When is it an overreaction?

Of course, when these companies deliver a dose of bad news, their shares can get pummeled. Yet we've all seen those quick sell-offs followed up by a nice rebound. The key is to quickly research the situation to see which sell-offs are deserved and signal "dead money" for the coming months, and which sell-offs are likely to be short-lived.
We can look to travel website (PCLN) as an example. Over the past few years, I've noted how investors tend to dump the stock whenever short-term trends lead the company to lower near-term guidance.

For example, in August 2011, I noted that a decent but not great outlook for the next quarter caused the stock to fall $100. Every time Priceline has fallen sharply in the past five years, it has rebounded in quick fashion. That's because investors again eventually focus on a great long-term growth story and learn to forget about the short-term blip in demand.

In the Priceline example, investors had a chance to profit from a slump in the share price when actual quarterly results were released. Yet in the past few quarters, we've seen an uptick in companies delivering bad news as a quarter is ending (known as a pre-announcement). That may be the result of a more aggressive Securities and Exchange Commission that is trying to crack down on trading activity on unreleased corporate information.

The template
Here's what I look for at the start of every trading day as we head toward the end of the quarter. I start with companies that are down sharply on the day (which you can find on Yahoo Finance or other sites). Many times, you'll see a few stocks that are off 15% to 20% as the companies deliver bad news on sales or profits.

1. Latest news
I first look to see if the problems are due simply to a delayed contract signing or a slow-to-be-released new product. Often times, the weakness in one quarter can mean that the next quarter will be just fine as that delayed contract is signed or that new product starts shipping.

2. The company's financial health
If a company has a weak balance sheet and can ill afford any profit troubles, I steer clear. However, if a company has lots of net cash, then it's in a position to defend its stock through buybacks. You often see such companies announce buyback plans a week or two after the pre-announcement. Such companies were simply unprepared for the drubbing that their stock received, and it takes a bit of time for a board of directors to convene and authorize the buyback program. I like to own that stock before a buyback program is announced.

3. What's the competition saying?

If a company's rivals note that industry conditions are solid, then the company in question is facing a favorable demand environment and needs to execute better on its sales plan. I also like to see how this stock is valued compared with its peers. If it has become much cheaper in terms of price-to-earnings or price-to-sales ratios, then it is bound to attract fresh interest from investors that seek out oversold stocks.
Watch and wait
It's important to move quickly because these downdrafts may not last for too long -- but it's also important not to act too hastily. That's because a stock can drift lower for a few more days after the pre-announcement, as mutual funds and hedge funds often need that much time to exit a position.

I like to see other investors begin the process of pushing that stock higher. I will gladly give up the first 5% or 10% of a rebound to be sure the sellers have mostly been flushed out of the stock.

Risks to consider:
As noted, you need to ensure that the company's shortfall won't lead to any sort of financial distress. It's wise to stick with companies that have the balance sheets that can absorb near-term body blows.

Action to take:
In the next few weeks, I'll focus on opportunities that have emerged from the upcoming pre-announcement season, utilizing the guideposts I've laid out. It's in this fairly small window that investors are treated to compelling buying opportunities, and a month from now, that window will have already closed.

David Sterman does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

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Have followed the same strategy, in the past. People tend to overreact to bad news. A downgrade, will have the same effect, as a poor quarterly report. Many times in premarket trading, or the first couple hours of trading, a stock will drop more than it should on a downgrade. JMHO 

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