Written by Evan Bleker Website
Buy on the cannons, sell on the trumpets.
A lot of investors seem to be making the same big mistake.
Have you ever heard the saying, “Buy on the cannons, sell on the trumpets“?
I was reading a topic thread on Facebook the other week when one of the commenters mentioned an online dating website that he was looking at investing in. He was impressed with the company’s solid earnings growth over the last few years, so decided to take a closer look.
When he peered into the latest results, his initial enthusiasm dissipated. Instead of seeing an increase in revenue, as he was expecting, he saw a sizable drop. What he thought was a strong, stable growing company turned out to be a company that had just run into a major problem.
Do you pass on companies going through major problems?
A lot of investors do, preferring to find strong, stable, growing companies that will continue to grow into the future.
Ironically, this practice makes finding great growing companies selling at great prices that much harder.
Great businesses with great prospects typically are never cheap.
But, as those who requested free net net stock ideas have already realized, companies that are facing major problems can bring major profits.
Evolution Hates Your Financial Future
Wayne Gretzky, Canada’s greatest hockey player (and evidently also Canada’s greatest investment adviser), used to say that you have to skate to where the puck is going to be, not to where the puck is.
In other words, whether you profit from a stock depends largely on what happens to the company going forward rather than what’s currently happening to the company.
That should help you put a company’s problems into perspective.
Instead of writing off a firm because it is suffering a large problem you really have to get a sense of where the company will be in a year or two.
That means understanding the current problem, the implications of the problem it’s facing, and what level of profitability the firm can enjoy once it’s free of the problem. Of course, if you’re a net net stock investor – (as you should be!) – then you don’t even have to assess the firm’s future profit potential.
Investors instinctively run from large problems.
This is part of our primal wiring.
When you’re clicking through Google Finance and spot a company that’s just been hammered by a large business problem, something deep within our ancient reptilian brain is triggered, causing you to panic, cover our wallets, close the browser window, turn off the computer, and hide under the towels in the closet.
We don’t see the opportunities that large business problems create.
A Crisis is a Terrible Thing to Waste
Typically, the stock prices of all businesses that suffer large business problems get pummeled.
As investors leave, they dump the stock in droves, sending the shares sharply downward. This can create a spectacularly cheap company in relation to net current asset value or in relation to what the company could earn under normal business conditions.
This is where a lot of money is made.
Warren Buffett famously bought American Express after the salad oil scandal. The company granted loans secured against large quantities of salad oil only to find out that the borrower had faked the amount of salad oil it had. American Express’ stock dropped by 50% as the company took a $58 million loss.
Soon after, Buffett started loading up on shares. When the scandal passed, Buffett’s holdings had appreciated handsomely.
There are numerous modern examples of crises working out very well for investors who had the stomach to buy at the point of peak pessimism.
Do you remember the BP oil spill?
Investors rushed to the exits as soon as they realized that there was a large problem.
BP’s ADR (BP) sank from $61.64USD at the start of 2010 all the way down to a low of $27 in June of that year.
Investors who had the courage to buy at a 50% discount to the previous high saw their shares increase to $44USD by year-end, a rise of 63%. Even if you were unlucky enough to buy before or after the point of peak pessimism, for example at a price of $35, then you still have a sizable 26% return.
Best Buy’s (BBY) earnings got crushed in 2012 and so did the stock.
The company’s stock price slid all the way down to $11.30 at the end of the year from a high of $27.50 in March. Investors who bought in during early January would have doubled their money only a few months later.
Trans World Entertainment (TWMC) is another recent example.
The firm, operating in the CD and DVD segment, suffered a large drop in demand when digital downloading became the norm. Its stock sank 96% from 2005 to the beginning of 2009.
After changing its product mix and closing unprofitable stores, it now trades at $4.10 – a 590% increase from its 2009 $0.59 low.
I bought two years after the stock bottomed, at a price of $1.50, then sold once the stock reached NCAV. That was enough for nearly a 100% gain in under a year.
GTSI Corp was caught doing something shady associated with bidding on US government contracts.
As a result, the firm was barred from bidding on Small Business Association contracts for 2 years. Since this was the company’s main focus, both sales and earnings were devastated and the CEO was fired. The stock tumbled into the $3 range where I picked it up.
With GTSI Corp, all an investor had to do was wait. The firm was barred from bidding on government contracts for 2 years – but not forever. It stood to reason that once the company’s ban was lifted then it would resume bidding on government contracts and both revenue and earnings would rebound.
This is an obvious point, yet the stock was still hit hard. I suspect this is because the market for stocks of tiny firms is far less efficient.
A few months after I purchased the stock, GTSI Corp was purchased by Unicom Systems for $7.75 per share and I netted an 85% gain.
Sangoma Tech was one of our free net net stock ideas.
Its legacy telephone landline business had been hit hard as digital communication started to take over in its industry. The company’s share price sank from $0.99 in 2010 to $0.18 in November of 2013. Investors who requested free net net stock ideas had a chance to buy Sangoma for that price and I myself purchased the stock at $0.20 per share.
To right the problem, the company started investing heavily in digital telephone technology and VOIP solutions. At the time of writing, the stock trades at $0.28, enough for a 55% increase in just two months. If the company is able to regain even half of its former profitability then the stock should rise much higher.
You Have to Spot the Fixable Problems
With most stocks you have to figure out whether the company’s problem is fixable.
Net net stocks like Trans World Entertainment, GTSI Corp, or Sangoma Tech are a different breed, however. Net net stocks have problems almost by definition, but a NCAV company doesn’t have to fix the problems it’s facing for net