The Great Strategy Of Trading On The Fundamentals

It is well known that the word "trading" is usually connected with technical analysis (moving averages, oscillators etc.) while the word "investing" is usually linked to fundamental analysis (P/E ratio, expected growth etc.). However, there are some opportune instances in which trading can be based solely on the fundamentals of a company.

These are instances in which a stock has plunged because of a piece of bad news or fears of an upcoming disaster. The key for the trader is to determine whether the risk for the company is just around the corner or the company has plenty of time to deal with its headwind. Moreover, the trader should only focus on the companies that have a great past record, a strong balance sheet (low debt) and an opportune valuation (low P/E). As long as these conditions are met, the trader should utilize the plunge in the stock price and bet on a temporary rebound, which will result in a pronounced, short-term profit.

It is important to realize that the positive scenario may ultimately be proven wrong. Nevertheless, as long as there is plenty of time ahead and the company possesses all the above virtues, it is almost certain that at some point the side with the positive expectations for the company will view the plunge as a unique opportunity and inevitably drive the price higher, at least temporarily.

Petrobras

The stock of Petrobras (PBR) plunged 11% yesterday on the news of a rise in the price of gasoline (4%) and diesel (8%), with the pricing parameters undisclosed "for commercial reasons". This is indeed bad news because the price hikes are probably not sufficient to render the downstream segment of the company highly profitable.

However, at the current stock price of $14, Petrobras is trading at an extremely low P/E=8 and is presenting a great short-term bargain. Its net debt is somewhat high at almost 10 times its annual profit but it is not intolerable. Sure it is a burden to the company that partly justifies the discounted stock price but one should not forget that the Brazilian government will help the company (through higher prices of the oil products) if the latter has great difficulty in servicing its debt.

Therefore, until the picture clears for Petrobras, it is very likely that the positive expectations for the company will temporarily prevail at some point and will lead the stock to a higher, more reasonable P/E ratio. A nice quick profit would be from the current price of $14 to the first technical resistance at $15, which represents a 7% profit.

As mentioned above, it is critical to realize that the positive expectations may ultimately be refuted but the important thing is that at some point they will temporarily raise the stock price to a more reasonable level till all the issues clear up.

Coach

The stock of Coach (COH) declined more than 10% to $48 after the last earnings report of the company. The report was not that disastrous but there were indications of the company losing market share to its great competitor, Michael Kors (KORS).

Nevertheless, at that level, the stock was trading at a P/E of just 13, which was really low for the sector. Moreover, it will take many months or years till the negative scenario for the company is realized (if ever) because there is still plenty of room for growth for both companies. Therefore, it was only reasonable to assume that the optimistic scenario for the company would temporarily drive the stock price up at some point and this is exactly what happened in the last month, in which the stock rose almost 20% on absolutely no news.

Yum Brands

Yum Brands (YUM) has incurred many unfortunate incidents in China in the last 12 months, including a scandal with antibiotics and the avian flu. The stock plunged in every piece of bad news but it quickly rebounded and is now trading at all-time highs. It is important to note that no-one knows whether or when the revenue in China, which is almost 50% of the total revenue of the company, will return to the level realized before the incidents but this has not prevented the stock from recording new highs; these new highs have been recorded thanks to the optimistic scenario for the company, even though no-one knows if it will ever materialize.

Note: This is a stock that usually trades at extremely optimistic valuations so it has always proved a great candidate for the strategy described in this article whenever it has been beaten by bad news.

International Business Machines

International Business Machines (IBM) has been one of the most controversial stocks in the last 2 years. It is remarkable that many respectable investors have strong but conflicting opinions on the future of the company. The fast transitional changes of the tech sector have raised worries about the future growth of the company and have caused the stock to extremely underperform the market in the last 2 years, falling 6% while Nasdaq has advanced 55% in the same period!

As the company has exhibited great resistance in its revenue and its net income, I believe it will take more than one year for the dust to settle and determine whether the company can keep innovating, as it has always done successfully in the past. Till that happens, I am sure that the stock will temporarily increase to at least $200 at some point, which corresponds to a P/E of about 12 given this year's EPS $17.

Conclusion

As mentioned in the above examples, it is important to understand that the final fate of the company is unknown; we are just trading based on the solid fundamentals of the companies, betting that the positive side will prevail for at least a few weeks within a year and drive the price to normal valuations. It is critical to focus only on strong companies with a good record and low debt so that we handle well our contrarian view. Otherwise, if we are not confident in the company, we will be inevitably forced (by human nature) to sell at a loss if the bad headlines keep beating the stock.

Source: The Great Strategy Of Trading On The Fundamentals

Disclosure: I am long PBR, IBM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. (More...)

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