Sunday, December 8th, 2019

Not All Depressed Stocks Will Recover

 

When the market corrects there are often bargains to be had. But not all depressed stocks will recover as things get better. This is the case with three energy stocks mentioned by the Motley Fool. They could lose you a lot of money.

Many investors are optimistic to a fault. Because of that, they see a beaten-down stock as an opportunity to profit in a subsequent recovery. Unfortunately, not all companies do recover because some are in such deep financial distress that the only solution is a debt restructuring or highly dilutive stock offering, either of which could lead to permanent losses for investors. Three companies that appear headed for that fate are Cobalt International Energy (NYSE:CIE), Seadrill (NYSE:SDRL), and California Resources (NYSE:CRC).

The problems for these companies are the same, not enough income and too much debt. Energy companies that survive until oil prices go up will be well postioned but many will fall by the wayside. Not all depressed energy stocks will recover. Don’t let them take your wealth down with them.

Analysis Is Critical

Seeking Alpha writes that you need to be able to distinguish between cheap stocks and value traps.

Very often, we can find good investment opportunities in stocks that are avoided or even shorted by many investors who are concerned about some issues the related companies are facing. Sometimes they get it right and the fundamentals of the company deteriorate, with the stock price spiraling down. Other times their thesis is wrong, or the company manages to solve the issues. Sometimes the issues fade away thanks to external events. These stocks, which tend to trade at low or depressed multiples, are sometimes mispriced as a result of exaggerated pessimism.

The writer uses Bed Bath and Beyond as an example. Like all too many bricks and mortar retailers the company is under pressure from Amazon.com and is fighting by offering coupons, discounts. The question is how much they can cut their profit margin and service. It is critical that before you invest in such a stock that you have a clear idea of how they will make money and continue to do so, their intrinsic value.

Intrinsic Stock Value

An unjustly depressed stock is a bargain and an justly depressed stock is a value trap. On our sister site, Profitable Investing Tips we wrote years ago about intrinsic stock value which helps you tell the difference.

The dictionary definition of intrinsic stock value is its fundamental value. It is obtained by adding up predicted future income of a stock and subtracting current price. It can also be seen as actual value of an equity versus its book value or market value.

The point is that if a depressed stock is likely to generate profits in the medium and long term which is why you would consider the stock a bargain, buy it and hold it. This is the formula.

V = (EPS x (8.5 + 2g) x 4.4)/Y

  • Earnings per share, EPS, for the preceding twelve months
  • A constant of 8.5 representing an expected price to earnings ratio, P/E ratio, for a company that is not growing
  • An estimate of long term growth, five years = g
  • A constant of 4.4 which was the average yield of high grade corporate bonds in the early 1960 decade
  • The current yield of AAA corporate bonds = Y
  • Where V = intrinsic value

When V is more than one the stock is undervalued and you should buy. When it is less than one the stock is overvalued and you should sell.

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