1. Poor management generating poor returns on investment. These companies can offer attractive buying because such companies are often taken over by competitors who think they can do it better.
2. Bad news creates opportunities because disgruntled shareholders tend to dump the stock. They dump the stock out of frustration, minimise exposure to more bad news, to punish the management. Whether its a law suit, a health scare, an oil spill, a mine collapse, or an earnings downgrade often bad news can have a silver lining.
3. Market shocks provide a great opportunity to buy stocks. The biggest challenge is identifying the best types of stocks to enter. They might be the worst performers, or you might buy good stocks similarly hit by the generally bad market sentiment. The best opportunities are presented by smaller stocks with good cashflows, though go for those with big share registers as these are more likely to experience many shareholders dumping the stock. In these circumstances, there is competitive pressure to unload the stock. Illiquid stocks tend not to display the same level of selling pressure and recover more quickly....thus illiquid stocks dont have the same psychological 'panic symptoms' that we like to see.
Trading strategy
The challenge is to understand the industry, how bad the news is before others, so that you can profit from any turnaround. There are 2 tools that you can use to profit from these opportunities:
1. Fundamental analysis: This is where you attempt to quantify the value of the company or the value written off, so you can determine if the comapny presents good value. You need an indication that the market has over-reacted because we are looking for bargains. The best indication is the pace of the fall, the amount of share turnover. We are more likely to see bargains if a higher volume of shares are traded, and we are more likely to get a position.
2. Technical analysis: We can look at charts and see the support and resistance levels, but its not necessarily easy to know which support a share might fall to. You might think it has support, then it falls further on its own or driven lower by further news.
If you can't quantify the value of the company post-bad news, you can still make money by using charts. In fact charts are critical for understanding
Want a strategy for buying blue chip stocks that will out-perform the market? Look no further than those making the headlines....for bad news that is. There are different strategies for different circumstances.
1. Short term strategies: This is where you are following sudden news announcements and you see an opportunity to profit from over-selling of a stock driven by shareholders motivated by fear. eg. In Japan there was a health scare when Snow Brand Milk reported that several customers had fallen ill after drinking its contaminated milk products. The CEO resigned, consumers stopped buying Snow Brand products, and millions were wiped off the companies stock value. Its safe to say however that the stock was always going to be over-sold. Why? Because the share price action was driven by short term news. Manufacturing capacity is very easily mobilised to produce new brands so a manufacturer can very easily regain the confidence of consumers if they offer discounts and sack senior staff. Also such companies offer compelling takeover targets. Whats important is that you recognise that the value of any asset is the discounted value of any cashflow. So a loss of income for 1 year has a mild significant (5%) on corporate value, but not the 20-30% we see shares sold to. The more tragic the news the better the buy because the greater the pressure for action.
2. Longer term strategies: This is where a company has been reporting a succession of poor results or bad news reports that have pushed the stock to new lows. The best way of finding these stocks is on the internet. CNN, Forbes and other media groups often report the best and worst corporate performers. eg. http://money.cnn.com/galleries/2007/fortune/0707/gallery.global500_losers.fortune/17.html
Trading tips
There are several things we can do to profit from bad news:
1. Dont always be fully invested otherwise you will likely never have spare cash for such opportunities. Alot of people feel compelled to always have their money in the market. Their attitude is...'you can't make money if you are not in the market'...true, but you can save alot.
2. Always have a buying and selling strategy. Have it written down, stating your rules. You dont need to learn a strategy from your mistakes, you can actually develop one based on historical price action (chart data). Analyse the charts for the type of stocks, bonds, etc you trade and establish rules.
3. Always follow your rules: If you break the rules, step away from the market and examine why. Dont re-enter the market until you have accepted the loss, so you are not emotionally charged. The same can be said for profits. Alot of people give away a good profit because they consider themselves high rollers turning tricks. This is not gambling. If profits bring out the worst traits in you, make it a rule to step away from the market after you take profits. If you are the type of person who cant follow rules, impress upon yourself the risks of arbitrary action.
4. Decide your trading period: You need to know from the start whether you are planning to hold the stock for a short period (a few days) or longer term. Periods of bad news draw alot of shareholders into the market place. For this reason expect alot of volatility. As the trading volumes quieten down, so does the volatility. Periods of volatility suit short term trading, but also large investors trying to take large positions. Expect market manipulation. Get as much news as possible so you can assess the upside or downside.
5. Cover contingencies: Read up on the company to determine whether there is likely to be any more bad news coming to the market that might push them to new lows.
6. Determine entry and exit points: The best basis for taking positions is a combination of fundamentals and technical (chart) analysis. For fundamentals, make sure you write down your reasons for buying and selling. If you decide to buy or sell, revisit these reasons. Same for your charts, follow the guidelines you have set for your trading. Write things down..as it makes your thinking more objective.
Trading Examples
Consider the link we found to the 25 most unprofitable companies. We note that they are listed on various exchanges - New York, London, Tokyo, Amsterdam. Most have American Depository Receipts on offer. From this list its apparent that there are a number of stocks that have recovered, so clearly these stocks have already turned around, so no longer offer compelling value. There were however 6 which have only recently reached lows, so we are interested in these. So we now need to consider:
1. Upside: Are these good industries to be in. I personally like all the industries that these companies are in, but might opt against Delphi because I dont know its business wel enough.
2. Charts: All these stocks are at chart support levels or close, so they are stocks that would interest us.
Just in case you cant read the charts - they are Tech Data Corp, Tyson Foods, Alacatel-Lucent, Sanyo Electric, Lear Corp and Delphi.
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