Twice a year bargain-minded investors have the opportunity to swoop down on stocks of company’s whose earnings release has led to a stiff drop in share price. Newcomers to investing are often tempted to follow a common sense investing strategy here. Good stocks that have gone down in price will eventually go back up. However, as many unfortunate investors have discovered, a stock that has gone down can stay down and even go down further.
When the price of a stock goes into free-fall after a poor earnings report, the Price to Earnings Ratio (P/E) goes down and the dividend yield for stocks that pay dividends goes up. This can make a stock look like a terrific bargain – a low entry point coupled with dividends to bank until the stock goes back up. But what some perceive to be a value stock may actually be a classic Value Trap – a condition where the stock price remains low or goes lower.
In truth seperating a value stock from a value trap is not an easy task, although investors can find a boat load of tips on the Internet about how to avoid value traps. Here are some of the most common tidbits of advice you might find:
• Is there high and growing demand for the company’s products or services?
• Is the industry in which the company operates growing?
• What is the company’s market share?
• Is market share growing?
• Does the company have strong competition?
• How much debt is the company carrying?
• Does the company have a history of earnings growth?
• Are company insiders buying or selling?
• Does the company have a potential catalyst in the near future?
There are others ranging from corporate fraud to accounting irregularites to management outlooks that border on fairy tales. Unfortunately not many experts give you any help differentiating the criteria. Few stocks would measure up against all the selection criteria. Are some criteria more important than others? Is a company with products in strong demand but high debt a value trap or a value stock?
One could make a strong case that the most important criterion by far is a potential catalyst. Think of a stock catalyst as any event that causes the share price to reverse direction. In reality it is almost always a catalyst of some form that causes a share price to drop. While one would assume a reported revenue or profit decline would be the chief culprit, this is not always the case.
A few days ago mining services provider Ausdrill Limited (ASL) reported a 63% drop in EBIT (Earnings before Interest and Taxes) and the share price went up. Apparently, management’s positive outlook on increasing demand from an improving gold mining sector satisfied investors.
Dig deeper into catalysts that have driven share prices up or down and we think you will find at its core a catalyst is all about demand for a company’s products. Companies that persist in offering outdated products will see diminishing demand and could go the way of once mighty Eastman Kodak. Nokia saw its position as global leader in cell phone sales evaporate in the face of the onslaught of smartphones.
In short, if you want to avoid value traps the place to begin your research is with the company’s products and the markets they serve.
We are going to look at five of the stocks that saw more than a 10% fall in share price following earnings release. Although the actual release dates differed, the summary table will include the one month percentage price change. Here is the table, listed in alphabetical order.
1 Month % Change
Earnings Growth Forecast
Average Earnings Growth
Ardent Leisure Group
Ardent Leisure Group (AAD) operates entertainment centres in Australia, including theme parks, health clubs, marinas, and bowling centres. In the United States the company operates a chain of family oriented entertainment centres. The company has made some key acquisitions in the health and fitness sector over the last few years and is now the largest health club operator in Australia. The Goodlife Health Clubs are currently Ardent’s largest revenue stream but the big growth story with this company is in the US where its Main Event Entertainment Centres are propsering, with more expansion planned. The stated goal is to reach 35 centres by 107, an increase of 21.
Given the global enthusiasm for better health and fitness it is little wonder Ardent is facing competition in this space. To gain a competitive advantage the company has been acquiring health clubs and plans to move to a 24/7 operation for its Goodlife clubs in 2015. The recent Half Year Results shocked investors as the company’s Full Year 2014 Results were outstanding. For the Half Year 2015 Ardent reported a 16% drop in profit, attributable in part to the opening of six new Main Event Centres in the US.
The share price had been rising steadily throughout 2014 until the seriousness of the falling oil price became apparent. Ardent’s US operation is headquarted in Texas as are the majority of the existing centres. Apparently investors were concerned cost-cutting in US oil operations could affect consumers in Texas, a large oil producing state. Here is a two year chart for Ardent Leisure.
The falling AUD is likely to benefit Ardent as Australians stay home and foreign tourists are attracted by the more favorable exchange rate. For catalysts watch for any news on expansion in the US, where Ardent has recently entered the US Midwest and the South with new Main Event Complexes.
The two biotech stocks in the table, Acrux Limited (ACR) and Prana Biotechnology Limited (PBT) are at the mercy of perhaps the most powerful catalyst on earth – the US FDA (Food and Drug Administration). No matter what the treatment, the holy grail of biotech companies is cracking the massive and lucrative US market. FDA approval is required before any treatment can be marketed and the approval process can be long and arduous. In addition, the FDA periodically issues Drug Safety Communications (DSC) regarding potential new concerns associated with the use of a particular drug. On 31 January 2014 the FDA issued a DSC regarding testoterone treatments, which included Axiron, the flagship testoserone treatment offered by Acrux. Predictably, the share price fell, although the FDA had merely announced it was investigating. The European Medicines Agency cleared Axiron in November 2014 and an FDA announcement is expected sometime in 2015, which could be the mother of all catalysts for Acrux.
Axiron is one of three products approved and marketed by Acrux using an innovative direct to the skin application technology. The demand for testoterone treatments will increase with an aging population and Axiron is already the second largest treatment in the US, with approximately 13% market share.
The company will need a hefty catalyst as the Half Year 2015 Results were not good, to say the least, with a 67% revenue drop and a 71% fall in net profit after tax (NPAT.) However, the company reports strong revenue growth in the rest of the world where its treatments are marketed. The share price is down close to 50% year over year and 70% over the last two years. Here is a two year price movement chart for ACR.
The company has four additional products in very early development phases and three having completed Phase 3 clinical trials. Compounding the company’s troubles is the royalty arrangement with US distributor Eli Lilly, with some payments expected to be deferred until later in 2015.
So is Acrux a Value Stock or a Value Trap? Certainly it is high risk but the answer to the question will come when the FDA finalises its inquiry. Axiron is already deemed safe in the rest of the world, with the kind of side-effect warnings required by many regulatory bodies. In the US the warnings are many and some speculate the worst case scenario for Acrux would be additional warnings. If the share price recovers following the FDA announcement, investors who took a chance will proudly proclaim they got in on a real “value” stock. If the share price falls further in response to a negative ruling, those who stayed away will proudly proclaim they avoided a “value” trap.
Prana Biotechnology Limited (PBT) has been working on treatments for degenerative diseases of the brain and the eye for some time, but has yet to get final approval for any of its treatments. However, given the size of the baby boomer generation entering their golden years, the market for treatments for diseases like Alzheimers is huge.
The Company had four treatments in various stages of the drug approval process, with PBT2, a treatment for Alzheimers , the furthest along in Phase 2 clinical trials. PBT2 is also meant to be a treatment for Huntington’s disease. The company also has treatment in the pipeline for Parkinsons Disease and brain cancer. PBT2 failed its first attempt at Phase 2 Trials and the stock price plummeted. Here is a five year chart for Prana.
Prior to the release of the FDA results the company had released positive preliminary research results and announced PBT2 was also in trials for treatment of Huntington’s disease. Press releases on the FDA Phase 2 Trials in progress heightened investor enthusiasm. The company went on the road to entice US investors, where the stock trades on the NASDAQ Capital Markets (CM). This all came crashing down with the poor results of the trials and the share price is now down 90% year over year.
The share price got a boost in September when the FDA granted Orphan Drug designation to PBT2 for the treatment of Huntington Disease. Orphan drug status is assigned to drugs for diseases that affect less than 200,000 people in the US.
The bump to $0.40 per share was short-lived, as the FDA issued a Partial Clinical Hold on the latest PBT2 trials following Prana’s request to begin Phase 3 Trials.
Is there any value left here? One could argue that investors buoyed by the size of the potential market for an effective treatment of Alzheimer’s may have overlooked the shortcomings of the product as well as the failure of other biotechs with this disease.
There is one thing to note about Prana before we move on. The company has no debt. If you check the Data Centre on thebull.com going back year by year, you will see Prana has had no trouble raising money through stock sales. Some of the placements came from sophisticated investors and one from a single individual. The point here is if there are people out there who believe in the product, debt is something that can be managed. What should worry investors is evidence of underscribed or cancelled share placements.
iiNet Limited (IIN) is our second largest DSL Internet Service Provider (ISP) with an enviable record of earnings growth. The company recently acquired Tech2, a technology services provider to commercial and consumer customers, and paid for it with a successful capital raise. The recent Half Year results showed positive revenue growth against profit growth that was essentially flat. Investors did not like what they heard. Here is the chart.
iiNet has rewarded its shareholders with total shareholder returns of around 30% over both three and five year periods. The NBN rollout of a fibre optic communications network should increase demand in a sector that is already high growth. iiNet is not without serious competition, but considering the scope of the ambitious NBN plans, there should be ample room for growth from multiple providers.
Some would look at IIN’s lofty gearing and smell trouble. Again, check the ASX news releases and you will see this company has had no trouble renewing its debt facilities. To reinforce the point; if a company has products and services in high demand, debt can be managed.
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