It’s now the time of year when many of us like to rewatch Rudolph the Red-Nosed Reindeer. Even if you’ve never seen it, you’ve probably heard of The Island of Misfit Toys – the destination for defective toys, deemed unworthy for people’s homes.
Now this movie is the perfect trading and investing reminder to look for misfit stocks. Generally, these are the ones that aren’t selling as well as they had in the past.
Maybe these companies’ products or services have fallen out of favor, or maybe people in charge have made poor business decisions, or recent acquisitions haven’t worked as anticipated. There are any number of reasons.
The best part is, these stocks are easy to spot, too because they typically sit at or near their 52-week lows.
That means you’re looking at the perfect opportunity to pinpoint the ones with the greatest turnaround – and profit potential.
And it all boils down to this simple strategy…
Why the Best Time to Buy a Stock Might Be When It’s at Its Worst
Do you believe over the year it has turnaround potential – to the tune of regaining 50% or more of its 52-week high price?
A few weeks ago, we talked about the Dead Cat Bounce options strategy. In the update, I revealed Macy’s, Inc. (M) and Sears Holdings Corporation (SHLD) as two stocks with the potential for quick profits via long call options.
In the charts above and below for M and SHLD (respectively), we can see the stocks hit at or near what were 52-week lows. Each was able to turn around for a quick pop.
But this isn’t just a Dog’s of the Dow (DOTD) investment idea. I am looking at all stocks in the Dow, not just the top 30. And this isn’t based upon company dividends, either.
However, what is similar between this Turnaround Strategy and DOTD investing is that I would consider a long-term equity anticipation securities (LEAP) option on it.
Now, I’m not saying there won’t be shorter-term trading opportunities throughout the year, but I’m not considering these as short-term trades at the start of the year. I see these as major long-term profit potential, so I’m not too inclined to concentrate on them for a quick pop right away.
If you do see a short-term technical pattern emerge on these stocks, I caution you to not worry about your LEAP option on our Turnaround Strategy.
If you do, you might be tempted to close your LEAP when you close the shorter-term technical pattern. Although that might seem like the best idea, you actually risk leaving money on the table for that LEAP option.
In most cases, the short-term pop isn’t going to be the 52-week high for this turnaround stock. And the whole purpose of the LEAP option was for a year-long hold perspective.
Important Things to Look for in a Turnaround Stock
Here are important things to consider before deciding upon a LEAP option target…
- Is there a new management team in place? Or are the same folks who got the company into the mess still around?
- Is the company going to produce and introduce a new product, technology, or service? And do you expect it will lead to better sales growth?
- Are the people in charge making appropriate decisions on operations and overhead: cutting jobs, reducing costs, streamlining operations?
- And always pay attention to a company’s debt. If the company’s bonds are trading at a discount, it may be more trouble than its worth. The company has to satisfy its debts to others before it can provide value to its shareholders.
While these aren’t the only criteria, it’s a great start. And if we can check off all of these bullet points for a compay, it may be a good target for our LEAP option.
But if the answer to most or all of the aforementioned points is “no,” it’s probably a sign to stay away from the company and look for other opportunities.
Once you have researched these items, it’s up to you and your financial team to decide to move on or consider a LEAP call option.
Realize, though, that a beaten-down stock is still a beaten-down stock. It’s not necessarity a good buy just because it’s trading at $5 now, but it used to be $30. We need to see that the company is capable of rectifying its existing problems before the stock actually has potential again.
A depreciated share price alone is not reason enough to consider a LEAP call option trade. Consider the words of Warren Buffet who said that “turnarounds seldom turn.”
Do your research and be patient. When you feel you have found a company that’s getting its mojo back, you may have just found the misfit toy that is worthy of a home in your portfolio.
Just make sure you bundle it in the form of a LEAP call option.
To your continued success,
Tom Gentile
America’s #1 Pattern Trader
