Welcome to
"StockBreakthroughs Newsletter"
January 27, 2005.
In this issue...
Making Profits On High Priced And Overvalued Stocks.
Last time I discussed; Buying on Bad News - Acquiring Undervalued Stock.
Today, I want to discuss the opposite. How you can make profits on HIGH PRICED and OVERVALUED stocks.
Last weeks plummet of eBay is a perfect example of this.
End of December 2004, eBay was trading close to $120.- and started dropping along with the overall bad market sentiment. Then, after the closing bell on Wednesday Jan.19, (the stock closed at $103.05) eBay reported its 4 th quarter earnings.
When the markets opened on Thursday, Jan.20, eBay plummeted as its fourth-quarter earnings fell short and a disappointing outlook raised concern about a slowdown in corporate profit growth.
eBay ended down $19.72, or 19.1%, at $83.33 amid a handful of analyst downgrades.
The online auction company's fourth-quarter earnings came up a cent short of analysts' average estimates, due to higher advertising costs and increased investment. The company also cut its first-quarter outlook.
But all the above wasn’t the only reason why eBay came short. It was just the trigger.
One reasons eBay came short is that it could have been overvalued. Lets see if this could be true.
The stock traded just under $120.- at the end of December. Now that is rather high considering that most stocks go for under $100.-
A large part of that was based on eBay’s faultless record of constantly beating quarterly financial forecasts. They never missed. Thus far.
For any other company the size of eBay, a growth of 44% in the final months of 2004 would have seemed unimaginable.
The Financial Times wrote this the next day in its article on eBay:
"After the breakneck speed of eBay’s ascent, though, it hinted at an encroaching maturity that might bring an end to it’s boisterous youth".
Well. The result was a 19.1% slump wiping $13bn from its stock market value.
The slowdown was particularly true in the US and Germany, eBay’s biggest markets. In the US, revenue growth slowed from 29% down to 24% in the preceding 3 months prompting fears it would be hard to keep the long-term growth rate above the promised 20%.
eBay’s non-US business slowed even faster, from 82 to 64%. Worse, the company’s rocksolid profit margins showed uncharacteristic signs of erosion.
eBay’s much admired business model – it holds no inventory but takes a cut of all transactions on its site – has enabled it to keep its profit margins above 80%.
But, what also cut into profit margins in 2004’s final months were heavier spending on marketing.
Chief executive Meg Whitman put the higher costs down to the seasonal effort to draw in more shoppers, though Christmas sales were lower than expected.
What fanned the biggest fears for eBay investors was that it would spend more to support a slipping growth rate, reducing profitability while failing to fend off an inevitable slowdown.
Considering all these factors one inevitably comes to the conclusion that eBay’s stock was overpriced. And in such a situation, the slightest negative news like failing to meet market expectations during the earnings season – even if it is just by 1 lousy little cent – can send a stock to the ground.
Now if you find a stock that is either overvalued or that is trading way beyond $100.- its a good idea to find out more about the company – especially its outlook for the future and what analysts say about it - and just observe it. As soon as the news around this company turns sour, the probability of its stock taking a dive is very high. You do get your exceptions, but they are rare.
So what you can then do is get in with a put option, where you profit when stocks go down, and wait until the dust around the company has settled. As soon as the stock goes up again – get out!
That a stock goes up again fairly quickly after a heavy drop is quite common because it is now available at a much cheaper price. Bargain hunters also took advantage of this with eBay that closed up $2.72 or 3.26% the next day.
Another reason could be that a drastic drop like the one with eBay was an overreaction and investors started buying again after they gathered their senses.
So investors that had put options on eBay or that got in just before the 19.1% slump, made
a huge profit in one single day.
It’ll be interesting to observe Google that is trading close to $190.- again.
Another way – although negative and sad unfortunately – you can profit with put options from stocks going down is after a negative event like 9/11. Disasters do offer opportunities and although these are indeed uninvited, we can non-the-less benefit from them.
On Tuesday, September 11. 2001, Wall Street and all other exchanges in the US stopped trading and remained closed until the following Monday.
What do you think happened that Monday after Wall Street opened up again for trading?
Right! The Markets went down. We were in a downward spiral anyway still due to the aftermath of the internet bubble bursting in March 2000. But 9/11 just did it then for the stock market.
Investors of put options must have had a big smile on their faces when they closed their positions some time thereafter.
Yours in Successful Trading,
Ricky Schmidt
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