Opportunities Abound in a Market That Tests the Downside
There are more and more opportunities to benefit from the miscalculations of other investors in the market.
It is no surprise that the market has continued to slide in the last month, drifting downward on headlines about a slowing economy, rising inflation, increased interest rates, and possible monsters under the bed (those imaginary hobgoblins about which investors perennially determine to be the detriment of financial world order).
Regardless of the reasons, there is no doubt now that U.S. investors are hunkering down for a bear market and a recession of indeterminate length.
Smart investors know, however, that this murky environment is just the stock market behaving as it always has. Stocks and the overall market rise and fall, ebb and flow, gain and decline, with a regularity that is now (and ever will be) unpredictable.
Since the last issue of the SmallCap Informer was published, roughly half a dozen covered stocks tested and then surpassed our previously-projected downside prices. These were mostly more economically-sensitive companies, such as those in or related to the housing industry.
Many other companies saw their share prices fall and land very close to our downside prices, leading to mathematically-driven upside/downside ratios that are stratospheric, in some cases reaching 50-to-1 or higher. What does this mean for these stocks?
As a refresher, our methodology incorporates an attempt to determine a likely future low price (downside) as well as a future high price (upside) for each stock under coverage. These prices are not “targets,” but a means of encapsulating the likely potential reward if the company performs as we expect and the likely highest risk if the company does not.
The difference from the current price to the selected high price is then divided by the difference from the current price to the selected low price, a calculation that results in an upside/downside (or reward-to-risk) ratio.
This effort allows us to compare the potential upside to the likeliest downside if a stock was purchased today, and we like to see a ratio of three-to-one or better (or three times the upside to the downside) before buying.
These calculations work well assuming that the analyst’s judgment is sound, and when applied to companies with a long, consistent growth record in a typical market.
For smaller companies, and/or during lengthy periods of excessive over- or under-valuation, the ratio becomes less useful. We utilize it in the SmallCap Informer as a reminder that the downside should always be considered, even if the upside/downside ratios are not as relevant for the companies we cover as for larger, more-established businesses.
Some long-time adherents of the Stock Selection Guide even go so far as to hold that it is not important to calculate the downside if you are truly focused on the long term. The upside of your potential investment is the most important factor to be considered.
In our current coverage list, subscribers will note in that a number of stocks this month have upside/downside ratios of 40- or 50-to-1 or higher. These should be interpreted not as absolute first-choice investments for new cash, or stocks for which there is truly the opportunity at present to invest in a stock and potentially earn 50 times more than you risk on the downside.
Rather, there are cases in which the market is actively recalculating the range of valuations at which those shares “should” trade. The market constantly and dynamically adjusts what it considers to be a fair price for a company, but the process often causes overcorrections one way or another. These excessive swings are what make it possible for individual stock-pickers to identify opportunities, but you must be able to interpret the signs correctly.
As always, fundamentals eventually rule, but it may take time for some companies with beaten-down prices to demonstrate to the market that they continue to have the right stuff to be winners.
From our perspective, the companies in the SmallCap Informer have already revealed the factors of good management that we demand. While some companies inevitably will take a fundamental turn for the worse and validate their low prices, most will recover from the market’s misjudgment and go on to deliver solid returns for shareholders.
The advantage of the current stock market is that it provides opportunities for investors to benefit from the miscalculations of other investors.
For example, the first of our feature stocks is a communications equipment maker that has a current stock price that simply does not match up with the company’s guidance for the rest of 2022.
Our second company recommendation may not fit everyone’s portfolio objectives, but it offers a high yield and the prospect of attractive total return in a business that has plenty of economic resilience.
And as always, stay the course!
- DOUGLAS GERLACH
Reprinted from the July 2022 issue of the SmallCap Informer.
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