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5 Earnings Trades for a Highly Correlated Market - 6000 views
MINNEAPOLIS (Stockpickr) -- The S&P 500 is within 50 points of the lows reached in early August 2011, and investors can expect the market to test these lows in the next week or two. Given that we are still a few weeks away from third-quarter earnings, there is a dearth of news that could provide support to stocks.
The correlation among the S&P's 250 largest stocks is at 81%, vs. the 30% historical average -- the highest it's been since 1987. Stocks are moving in lock step, irrespective of individual fundamentals, which indicates a high degree of fear and inefficiency in the market.
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What can break the spell of high correlation? Last week, several stocks releasing earnings results moved independently of the market in the moments of trading after news was released -- moments that provide a small window of opportunity during which fundamentals actually matter. Traders getting a good read on where the numbers will come in relation to Wall Street estimates can make big money trading stocks during this time of high correlation.
Here are my thoughts on five earnings trades for a highly correlated market.
How low can stocks go? Shares of home style restaurant, Cracker Barrel (CBRL) have fallen hard, down 30% since the beginning of the year. Helping the bear case is operating performance that has missed expectations in each of the last two quarters.
Are things really that bad for the company? I don’t think so. The earnings misses have been miniscule, not deserving of such punishment in the market. This stock is correlated to a market that is in decline.
With the selling in Cracker Barrel, shares are cheap heading into the earnings report on Tuesday. Average estimates for the quarter ended July 31 are for 96 cents per share. That number has adjusted lower from the $1.02-per-share average estimate 90 days ago.
For the full year ended on the same date, the average earnings estimate is for the company to make $3.81 per share. In the next year, profits are expected to grow by 11% to $4.24 per share. At current prices, shares trade for less than 10 times earnings. If estimates beat earnings, look for this stock to move 5% higher or more.
While the majority of stocks may be highly correlated at the moment, there are a few stocks doing well despite overall market weakness. For these names, earnings growth is strong and operating results are exceeding expectations. As a result, investors are bidding up prices when profits beat estimates.
One such stock is Ulta Salon (ULTA). Despite trading for 34 times current-year estimated earnings, the stock gained 14% on Friday after a solid profit report that exceeded estimates and included increased guidance for the future. Another stock that may do similarly well this week is K12 (LRN).
The kindergarten through 12th grade online educational services company reports earnings results for the period ended June 30 on Tuesday after the market closes. Shares of K12 have shed 32% since May. Those losses make little sense for a company expected to grow profits by more than 100% over the next 12 months.
With the selling, investors can now buy the stock for 60 times estimated earnings for the 2012 fiscal year ended June 30. That may seem expensive but is in fact reasonable given expected earnings growth. While the company has missed expectations in each of the last three quarters, look for that trend to be broken with the current report. If so, shares could quickly recover that 30% of lost value.
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It has been a rough year for big box electronics retailer Best Buy (BBY); shares have lost 29% so far. The company reports results for the quarter ended Aug. 30 on Tuesday. Although smartphone sales have been strong, Best Buy has seen an erosion of overall business that has resulted in stalled earnings growth.
In response, management is tweaking its business model, attempting to focus on smaller retail outlets. Over the last two quarters, the company has beaten earnings estimates. For the current quarter, the average Wall Street estimate is for the company to make 53 cents per share. For the full year ending Feb. 28, 2012, the expectation is for a profit of $3.48 per share.
At current prices, shares of Best Buy trade for just 7 times current-year estimates of earnings. Clearly the market is skeptical of the company's moving the needle with respect to earnings. After Best Buy reported results last quarter, shares jumped. To the extent the company can surprise to the upside this quarter, Best Buy shares should rally impressively.
Best Buy, one of Jim Cramer's Stocks to Watch this week, is one of the top holdings of David Einhorn's Greenlight Capital.
Within the fog of fear, there are businesses that are performing well, operating with a model that connects with the marketplace. Diamond Foods (DMND) is a seller of snack foods primarily in the nut category. With a growing emphasis on smaller portions, including a healthy dose of nuts, Diamond is poised for growth no matter where the economy goes from here.
As a food company, Diamond is a bit of a defensive play to begin with. While shares dipped in July, they bounced back in August. On an operating basis, the company is doing very well. It has exceeded Wall Street average estimates in each of the last four quarters. Look for another beat when the company reports results for the quarter and year ended July 31 on Thursday after the market closes.
For the full year, the company is expected to make a profit of $2.53 per share. In the next year, earnings are anticipated to grow by 22% to $3.10. Shares of Diamond trade for 23 times forward earnings. The higher valuation will put a ceiling on what the stock does after it reports results on Thursday. I’m looking for the stock to gain 3% to 5% in the day of trading on Friday with strong results.
Diamond Foods is also on Cramer's list of stocks to watch this week.
Pier 1 Imports
Exploiting the high correlation in the market can be explosive when trading a stock that has seen shares swing wildly. The volatility combined with a news event such as earnings results can move a stock significantly in one day of trading. If you're on the right side of the trade, big gains can be had.
Pier 1 Imports (PIR) has been on a rollercoaster in 2011. Shares are essentially flat for the year, after oscillating between a peak of $12.50 per share and a low of $9 per share. The latest move had the stock dropping hard in July. In a span of two weeks, the stock went from $12 per share to $9 per share. An August recovery pushed shares back to around $10.50 per share today.
Investors can expect another wild ride when the company reports earnings results for the quarter ended Aug. 31 on Thursday. Pier 1 has met or exceeded average Wall Street estimates in each of the last four quarters. For the full year ending Feb. 28, 2012, the company is expected to make 81 cents per share. In the following year, profits estimates grow 17% to 95 cents per share.
With the stock trading for only 13 times current fiscal-year estimated earnings, the stock is coiled to move in a big way when results are released on Thursday. Given past performance, traders can expect another solid report. If so, the stock should jump.
To see these stocks in action, visit the 5 Earnings Stocks for a Highly Correlated Market portfolio.
-- Written by Jamie Dlugosch in Minneapolis.
At the time of publication, author had no positions in stocks mentioned.
Jamie Dlugosch is a founder and contributor to MainStreet Investor and MainStreet Accredited Investor. Formerly, he was president and CEO of Al Frank Asset Management. He has contributed editorially to The Rational Investor, The Prudent Speculator, Penny Stock Winners and InvestorPlace Media.