Stocks only go up in one of two ways. Either earnings are improving, or investors are willing to pay more. When investors are willing to pay more, it’s called “multiple expansion” on Wall Street. Likewise, when earnings falter or investors don’t want to pay up for a company, shares decline (multiple contraction). When it comes down to it, those are the two ways you make money from changing stock prices.
Today, investors are generally willing to pay a premium multiple for stocks. My preferred poster child for this phenomenon at the moment is The Hershey Company (HSY). It’s a great company. It’s hard to find someone who doesn’t love chocolate. But investors love the confectioner a bit too much for a big, slow-growing business. Shares trade at 40 times earnings and are trending higher. That’s a high price to pay to indulge a sweet tooth, and shows how much of this market rally has been based on multiple expansion.
Buying stocks with markets moving to new all-time highs is tricky business. A better strategy is to find companies that have bucked the trend. I’m talking about buying shares of companies that are closer to 52-week lows than 52-week highs.
The benefits are obvious. First and foremost, such companies have already sold off heavily. They might sell off more if the broad market does—most stocks will follow a big trend. But if they haven’t been on the uptrend, they have a good possibility of seeing a multiple expansion as other stocks contract. That gives us a better upside opportunity than paying 40 times earnings for a company like Hershey and hoping someone will be willing to pay 50. Such a buyer may not materialize.
Second, a company with a big selloff can trade at a big value. For investors looking for a catalyst for higher prices, sometimes value alone is enough. Buying beaten down names when they can’t seem to catch a break and look likely to break even lower can prove to be successful in time. Lower prices mean better dividend yields, a lower hurdle to upside surprises, and a far cheaper price for assets that may entice a competitor to make an offer. Those are all good signs.
As with any investment, it’s not just about the valuation. It’s about having the patience to see the trade work itself out. And as long as a company is doing well operationally, chances are it will recover in time and come back into the market’s favor. But patience in the name of the game. It’s not a strategy where you can buy on a Monday and expect profits by Friday. It takes time, and investors will spend long months sweating it out in the meantime.
But it’s worth the wait. Despite many big-name stocks hovering near all-time highs, many companies haven’t gone along for the ride. Here are three where I’m quietly putting money to work in the overly-beaten-down theme:
American Outdoor Brands Companies (AOBC). I’ve been a fan of the firearms space for a while now. I initially bought shares on the thesis that the firearms companies weren’t reflecting the pre-election surge in gun sales. That led to a great value.
Today, there’s an even bigger value in the sector. That doesn’t make sense from a political standpoint. After all, markets were pricing in an industry that would likely be hamstrung or even shut down, given the powerful anti-gun rhetoric of Hillary Clinton. In fact, it was an issue that put her to the left of Bernie Sanders during the primaries! Clearly, the industry was clearly facing an existential crisis before the election. But that’s long past.
With that fear of an industry shutdown out of the way thanks to the election, shares should have risen on the news, not fallen. Fears that can cause a stock to drop to zero are worth paying more attention to than a run-of-the-mill fear that could lead to a simple 10 or 20 percent decline.
However, the immediate post-election declining sales trend is reversing. And with it, I expect firearms companies like AOBC to keep moving up off their politically-driven depressed levels.
Chicago Bridge & Iron (CBI). This infrastructure company can’t seem to catch a break. Shares have fallen by over one third since it posted earnings, and the board of directors recently booted the company’s CEO. What’s going on?
Simply put, the company is doing fine operationally, but not exceptionally well. And despite selling off its nuclear-energy business a few years back, there’s currently fear that the company bears some liability for that business. However, the company took that liability off the table when it sold that business to Westinghouse. Fears of some kind of claw back are keeping a lid on shares now, but as that fear disappears, the share price should move much higher.
The company has a huge backlog of projects, and will likely be a key beneficiary from increased infrastructure spending in the future. I’m not too worried about the company’s long-term prospects. Just ignore the short-term fears.
Michael Kors (KORS). The luxury brand makes handbags and other fashion accessories. There’s just one problem. Its products are saturated in the United States and Europe. The quality of their products also means that consumers aren’t exactly looking to make big replacements anytime soon.
But that’s not a problem. Even with a hugely saturated market, the company is posting strong earnings and generating tremendous cash flow for investors. And its balance sheet is clean, with lots of cash and nearly no debt. It will survive the latest slump. More importantly, the company is looking to expand in Asian markets, with a large consumer base who isn’t yet saturated with the company’s products.
Those are just three very different companies in three very different industries. They’re all down for different reasons—but there’s a common thread. The market doesn’t expect much of them right now. That’s a far cry from the average stock, where the market expects a lot from even the slowest-growing names. I know where I’d rather invest right now.
Andrew Packer is a Senior Financial Editor with Newsmax Media. He currently writes the Insider Hotline investment advisory, serves as investment director for the Financial Braintrust, and writes the monthly newsletter Crisis Point Investor.
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