Friday, February 9, 2007
After 20 years of trading stocks, I've learned that when a company trades for more than 40 times earnings, you can start thinking about a short sale...
Conversely, when a stock is trading for less than four times earnings, you can start thinking, "buy."
You don't often see stocks trade at less than four times earnings. When it happens, it's usually because investors have soured on an industry and expect earnings to fall dramatically over the next year. So they dump their shares, and the stock price reflects the worst of all possible worlds.
That was certainly the case last July when we recommended call options on luxury homebuilder Toll Brothers (TOL). TOL was trading just above $23 per share, at a P/E ratio of 4x.
All the housing stocks were depressed then – and rightly so, given the grim future the industry faced. But at just four times earnings, it was reasonable to figure that investors had already factored in the worst-case scenario. And we did quite well with that bet, making 150% in about four days.
Today, the earnings picture for the housing sector isn't much brighter than it was last July. But TOL's share price is 40% higher.
That has me looking for more trades in housing and housing–related stocks... stock like Encore Wire (WIRE). WIRE is a low-cost producer of copper electrical wire and cable. The slowdown in the housing sector has certainly hurt Encore's business. And the recent contraction in copper prices hasn't done it any favors, either. But at less than four times earnings, investors were pricing WIRE for total disaster.
Late last month, WIRE spiked up 10%. Even after a disappointing earnings announcement on Tuesday, WIRE quickly recovered. S&A Short Report readers who took my advice sold half of their calls for a 65% gain, and we're still holding half of the position at 33%.
WIRE's movement tells me that there's no disaster ahead for the housing market... and the cheapness in the sector has me looking for more buying opportunities. For two months in a row now, we've seen a larger-than-expected increase in housing starts. And just as that news has helped prop up the stock prices of homebuilders, it'll trickle down to the homebuilder suppliers.
Best regards and good trading,
Foreign telecom companies America Movil (Latin America) and NTT DoCoMo (Japan) hit new highs.
Mortgage REIT New Century Financial plummets 36%, hits new 52-week low.
Retail continues to surge... new highs for Target, Tiffany, Aeropostale, Men's Wearhouse, Abercrombie & Fitch, and Coach.