Bad news doesn’t always plague an entire industry. More often, it is company specific. But a little floundering can work in your favor.
Getting into a long-term stock during a downturn can significantly improve your profits. Following are a few examples of bad news that made for great buying opportunities.
Microsoft
In December 1997, the Department of Justice (DOJ) obtained a temporary injunction to prevent Microsoft from shipping its Win- dows operating system bundled with its Internet Explorer browser.
The DOJ felt that this exclusive arrangement was monopolistic.
On the heels of the announcement, Microsoft stock took a huge hit. Many investors felt that Microsoft was going down. In reality, the injunction was no big deal.
Microsoft was a powerhouse—it had the money and the where- withal to fight the system. Plus, anyone following Microsoft knew that a new version of Windows (Windows 98) would be released in a few months. Investors who bothered to look at the company’s history would have seen that every single past product release had affected Microsoft stock favorably. Armed with that knowledge, smart investors worked the DOJ announcement; while everyone else was panicking, they bought Microsoft cheap, knowing that the stock would probably rise when Windows 98 shipped.
If you had been this smart investor, you would have bought the stock at around 70 and seen it shoot past 100 only four months later. You would not, as most people did, have bought it in June, when Microsoft won an appeal of the temporary injunction and the stock soared (see Figure 3.1).
Repeat after me: Buy low, sell high.Do not buy when everyone is euphoric. Buy when everyone is scared.
Gateway
Gateway didn’t start the new millennium off with a bang, it started it with a whimper. In January, the company publicly announced that it had failed to meet the numbers it had promised investors for the end of fiscal year 1999.
Gateway had a story—there’s always a story. No company wants you to believe that its revenue growth is rapidly decreasing, so companies give things a spin.
Now, I like Gateway. It’s not a high-growth company (in this book’s definition of the term), but it’s a strong one. The company has good products and an excellent management team. All the fundamentals are there.
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Gateway’s spin on the missed quarter was that it wasn’t the company’s fault. Gateway blamed an Intel chip shortage and the Taiwan earthquake. I wanted to believe that Gateway’s low revenue in the previous quarter had been a temporary glitch due to things beyond the company’s control. I wanted to believe this because if it were true, it would be a great time for my clients to buy Gateway stock, which had plunged after the announcement.
Gateway’s problems had started in early December. Intel ran out of the chips Gateway needed for its high-end machines. Intel A few examples of how news has affected Microsoft’s share price*:
June 1998 A federal appeals court lifts a previous injunc- tion that restricted the sale of Windows 95 bun- dled with Internet Explorer. Shares jump over 20 points, from 84 to 105.
November 1999 Judge Jackson issues his findings of fact, using the term monopoly powermore than two dozen times in his short statement. Microsoft trading is five times normal volume the day of the announcement, with 122 million shares chang- ing hands.
March 2000 Microsoft moves to settle. On the news, shares rise 10 points to 112 by the end of the month.
April 3, 2000 Shares plummet to 90 on news that Jackson will rule.
April 24, 2000 Shares drop down to 66.50 when the govern- ment announces it will push for the breakup of Microsoft.
June 2000 Microsoft declares it will appeal Jackson’s deci- sion to break the company in two by taking the case to the Supreme Court. The stock rises to 80 on the news.
Figure 3.1 The Rise (and Fall) of Microsoft.
*All share prices adjusted for splits
assured Gateway that the problem would be solved in time for the Christmas season, but it was tight.
At about the same time, Gateway was dealt another blow.
Because of an earthquake in Taiwan, companies were short on com- ponents. Prices of DRAM (dynamic random-access memory), a par- ticularly expensive component, shot up drastically.
For those who don’t know, Gateway, like Dell, sells computers directly to the public and takes advantage of small inventory. (As discussed in Chapter 6, keeping a smaller inventory is a huge advantage to direct merchants—known as “directs” in the busi- ness—because traditionally, the price of components keeps going down). Gateway, as a rule, doesn’t hold much DRAM inventory.
This usually works in its favor; buying DRAM units later means buy- ing them cheaper. But once in a blue moon a component will spike up in price, and this, according to Gateway, was one of those times.
Christmas shopping season hit, and Gateway still didn’t have the chips. The company had placed a sea of ads promising hot new computers built around that specific chip, and while in most sea- sons customers would be willing to wait until the chips arrived, at Christmas time they were impatient. Gateway lost those sales com- pletely.
There was also another set of customers, customers whose orders had already been processed and who had been promised that machines with the new chip would arrive by Christmas. Gate- way, known for its fantastic customer service, couldn’t let those customers down, especially during the holidays. So it gave them machines with an even better chip, for the same price. This may have kept customers happy, but it brought Gateway’s profits for the quarter down even further.
That was the Gateway story. Did I believe it? Yes. I’d read about the Taiwan earthquake, I’d heard from Dell and other direct sell- ers that Intel had been short on chips, and I’d looked up DRAM prices on the Internet to see if they had indeed gone up. All of it checked out.
After investigating, I trusted Gateway. I believed that the com- pany’s misfortune was a temporary phenomenon, not a permanent one, although the stock did not reflect that. But while I believed Gateway, I felt that some of its problems would persist through the
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March quarter. I told my clients to wait until May, by which time I expected that the stock would be at a very attractive price.
Hewlett-Packard
Hewlett-Packard (HP) isn’t a high-growth company, but it’s a great example of how a stock can take a roller-coaster ride up and down the Dow in a relatively short period of time. To me, HP is the poster child for the importance of buying a stock at the right time.
HP is no VA Linux—it will probably never go up by several hundred percent in a week’s time. HP is probably a 10 to 15 per- cent grower when things are going well, 5 to 10 percent when they’re not. The company may not be a hot young thing, but it’s been pretty consistent over the past decade or so.
When the Asian Crisis hit, HP was dramatically affected. HP’s revenue growth rate went from 10, to 5, to 4 percent, and then sunk close to 1 percent by the end of 1998. Wall Street was looking at those quarters and saying “Things are terrible at HP,” and the stock reflected that assessment. It basically collapsed.
Looking at HP in February 1999, I saw things differently. HP was trading at a profit-to-earnings (P/E) ratio of 21, 5 points lower than the average company in the S&P 500.
Now HP had had trouble in Asia, no doubt about it, but it was at its heart a strong company, at least as strong as the average S&P corporation. I felt the stock was unfairly underappreciated. If its P/E went up just enough to match the S&P average—in other words, if HP got just a normal P/E ratio, nothing drastic—the stock would go up by 25 percent. And if HP actually showed some growth in the quarter, I thought that many investors and analysts
T H E P R I C E - T O - E A R N I N G S ( P / E ) R A T I O
= price of stock
one year’s earnings per share P
E
would happily get on board. I told clients to get into HP in Feb- ruary, while it was low.
Five months later, HP’s stock had appreciated from $70.50 a share to $107 a share. Why? Well, it wasn’t the earnings. The esti- mated earnings for fiscal 1999 had increased from $3.35 a share to
$3.55—only 20 cents—but the P/E had shot up considerably. Now it was 30.1, several points higherthan the S&P average. The stock’s meteoric rise had almost nothing to do with performance and everything to do with perception. Most of the appreciation of the stock happened because the Street was excited about HP again. In my opinion, it was time to sell.
I suggested selling because HP was, at its core, the same com- pany it had been six months before. It was a company growing at 5 to 15 percent annually, and now it was trading at a premiumto the S&P 500, not a discount. It was no longer a value play.
By November, HP was cheap again. It was a buyer’s market. By February 2000 it was time to sell.