I’ve got a friend who’s an emerging investor. His current strategy is to take advantage of market inefficiencies due to COVID-19 and buy beleaguered stocks. In theory, this is a great way to generate some alpha and outperform the markets—this is the same guiding investing principles of Warren Buffet and Benjamin Graham.
The difference between Buffet and my friend is that, unlike Buffet, he doesn’t have a team to help him conduct proper due diligence, nor does he have the financial background to dive deep and really understand the businesses he invests in. Instead, like when I first started investing, he looks at the historical stock price and buys the stock in a company he recognizes the product. The companies he purchases are trading at a huge discount to their stock prices before COVID-19.
I’ve gotten lucky a few times and had the strategy work; however, I ended up losing more than I expected in most cases. My friend hasn’t made the mistakes I have and was confident enough in his strategy that he ended up placing a bet with me. The loser has to cook dinner for the winner while wearing an apron with the winner’s face.
Today, we’ll take deep dive into the risks in buying the dips, the proper way to buy the dip, and the outcome of our bet.
Eenie, Meenie, Miney, Moe; catch a falling knife by the toe
Buying the dip is entirely market timing. It takes a lot of experience to feel when the market has bottomed out on a stock, and it’s time to buy. The biggest mistake anyone can make is to buy a stock prematurely on its way down—this is often, in the business, called catching a falling knife. Consequentially, the fear of buying too early can cause an investor to sit on the sidelines for too long and miss out when the stock recovers. In that case, how do investors or traders time their buys?
A candlestick chart is different than the line graph as it is presented by vertical bars that are either filled in or identified with colors.
Investors using technical analysis attempt to time the markets by looking at patterns of prices and trading volume. Dating back to the Meiji period of the 18th century in Japan, Munehisa Homma was a rice trader and is believed to be the candlestick charts' inventor as he mapped out the supply and demand for rice.
Wikipedia on Candlestick charts
For technical analysis to work, traders look at past prices and volumes to help determine future prices. Instead of seeing price as the absolute value of an asset, technicians, investors who rely on technical analysis read the price movements as a barometer for the market's overall psychology. After all, markets are comprised of transactions between humans, and humans are emotional.
Common indicators used in technical analysis include the RSI, support levels, moving averages, and price by volume. To be completely honest, I am a fairly lousy technician. I don’t day-trade stocks, forex, options, or commodities enough for me to invest more of my time into getting better. However, I have included some links above to Tastytrade—these folks put out incredible content and have been in the industry for years. I have to say the only negative thing about Tastytrade is that it’s not at all beginners friendly. Emerging investors will feel lost trying to keep up with the fast-paced jargon and lingo.
To get started learning the basics today, sign-up for early access to Archimedes.
Cheap for a reason
The technical analysis starts breaking down by itself if there’s a fundamental shift in the underlying business, altering how investors view the company or stock. Looking at charts alone, these changes are impossible to spot until they have already happened.
Everyone loves a good debate, and there are investors and traders out there who will swear and die by either technical analysis or fundamental analysis. I think it’s foolish for an emerging investor to be caught up in this philosophical debate and end up being dismissive of either. As the tweet indicates above (in response to someone dismissing fundamentals), the price of a security is determined by the supply and demand and market participants' psychology at the end of the day. No matter how great the business, as a shareholder, if no one wants to buy your shares, they are illiquid and valueless.
Most market participants are rational and will invest and buy shares on the condition that the business can create value in the future and return capital to the shareholders. This expectation is why I firmly believe a basic understanding of how businesses operate and financial statements are required for every emerging investor to succeed. And in the case of my friend, he went digging in the bargain bin. He had no idea what stocks were cheap because the business prospects of returning capital have deteriorated instead of being completely mispriced by the market.
Let’s look at an example of a cheap stock that won’t be trading at pre-COVID levels anytime soon.
Boeing (NYSE: BA)
Boeing has been a good stock and a company with a solid balance sheet. Recently, it’s been a disastrous ride for BA shareholders. In 2017, the company introduced a brand new airplane that was supposed to usher in a new generation of consumer aviation. The 737 MAX was more fuel-efficient, could go longer distances, and had the most advanced electronics. However, a design flaw in its sensors caused two fatal crashes, and as of May 2019, all 737 MAX planes have been grounded, and the stock price dropped from highs of $440 per share.
As Boeing was scrambling to contain the brand's damage and bring the 737 MAX back into service, the pandemic delivered another solid kick to the chest. International flights were canceled, and domestic travel was limited to essential only. The airline industry, Boeing’s largest market, landed in dire straights with no revenue coming in and massive operational costs of keeping their crew on payroll and servicing the idle planes.
Without the immediate need for more capacity, airlines started cutting costs and canceled Boeing's future orders, causing the stock price to crater. At the time of this writing, the stock is down over 50% for the year and has only returned 24% over the last 5 years compared to 75% by the S&P500.
Boeing has diversified revenue streams due to three major lines of business.
- ✈️ Most folks are familiar with the wide-body commercial aircraft we’ve all be on, such as the Dreamliner; Boeing designs and manufactures airplanes to be sold directly to airlines or airplane lessors, businesses that lease airplanes to airlines.
- 🚀 Boeing is also a major player in the aerospace and defense industry alongside Lockheed Martin, Raytheon, and Northrop Gruman. Outside of commercial jets, Boeing manufactures military aircraft and missiles.
- 📦 Lastly, Boeing also has a services arm to provide customers training; engineering and maintenance; analytics; and supply chain and logistics support.
Boeing’s latest 10-Q shows revenue and earnings breakdown across lines of business
Out of the 3 lines of business, the aerospace and defense industry is the most stable. As a country, we will always need to defend ourselves. The military budget has been largely protected on a bipartisan level as different presidents have come and go, and the congressional majority switched from one party to the other. Additionally, government contracts are large and extend over long periods of time—once Boeing wins the bid of a contract, contraction or churn is unlikely.
On the other hand, the commercial airplanes industry is very different and is largely cyclical. It has been heavily impacted by airlines' discontinued operations. From the financial statement above, we see that Boeing booked less than half the revenue for the commercial airplane business compared to this time last year, even with the 737 MAX issues.
The global services industry will likely contract for the engineering, training, and maintenance portion. While people are working at home, the consumption of goods still occurs and bolsters the need for supply chain and global logistics. We see only a 14% contraction compared to last year.
Overall, revenue is down to $42,854 for the past 3 quarters compared to $58,648 reported last year. The difference comes out to be roughly a 27% decline.
Despite the large dropoff in revenue for the past 10 months, Boeing currently has $10.6 billion in the bank, more cash than last year, with no immediate threat of being insolvent.
Boeing’s posted losses for the most recent quarter were better than everyone expected after getting some costs under control from the ugly second quarter. The company burned through $5.1 billion in cash compared to $5.6 billion the quarter prior. In this case, slowing the hemorrhaging of cash is vital for the business’s survival.
Pfizer’s most recent vaccine results brought a huge wave of hope and relief to Americans who have been stuck at home for the past 10 months. Beleaguered airline stocks jumped 25% on the day that the results of the vaccine were released. Investors are hopeful that with the COVID-19 vaccine, life will quickly return to normal, as will the travel industry. The optimism extended to Boeing’s stock as BA jumped to $180 per share.
Additionally, the Federal Aviation Administration reported plans to recertify the 737 MAX for commercial service as soon as November 18, with the regulators in Europe following close behind.
However, even with all of this good news, BA shares are still trading 50% lower. Let’s summarize quickly what we know:
- Revenue is currently down 27%, with aerospace and services providing stability.
- Stronger cash position than last year.
- Positive vaccine news may mean travel returns to pre-COVID levels 2 years from now, and commercial airline revenue will recover soon.
- 737 MAX is allowed to fly again, and the rest of the deliveries can be completed.
A 50% discount seems stern for only a 27% drop on top-line and tighter margins. Could BA stock be underpriced?
The bad and ugly
I am sure the question on everyone’s mind is, what is the source of cash if the business hasn’t been profitable? Boeing has been borrowing money hand over fist with their debt load increasing to a little over $57 billion compared to $20 billion the year before.
Debt in the form of bonds isn’t necessarily bad for companies. Bonds offer established companies a much cheaper alternative of raising cash compared to selling stock or equity. To compensate lenders for the decreased return, bonds offer a safer way to invest in a company because all bonds and interests need to be paid first before stockholders see a dime from the company. The amount of debt a company takes on increases the financial leverage of the company.
Let’s take a quick look at how debt can create leverage in a simple example of buying a home. Let’s assume, for easy math, our vacation home costs $100K, and we put a 20% down payment and finance the remaining 80% of the purchase with a mortgage. Effectively, we are investing $20K and borrowing $80K to buy the property. Now let’s assume the property appreciates 20% over 5 years to be appraised at $120K. We have invested $20K into a house worth $20K more, netting us a 100% return over 5 years. The leverage we applied by borrowing money allows us to generate 5x the return we would have had we only earned 20% on our $20K. This leverage works the same for upside AND downside.
Boeing is currently borrowing and greatly increasing its financial leverage in hopes of a better future outcome, and the company isn’t planning to stop at $57 billion. Management has been working recently with investors on a new $12 billion debt package. Boeing's disclosures indicate that $3.6 billion of the new debt may be used to pay off existing loans. For many, panic alarms may be going off right now as this seems strangely familiar to borrowing from one credit card to pay off another. To offer Boeing some benefit of the doubt, it’s more likely that the current interest rates are low enough that it makes sense to do so.
The bigger issue is Boeing’s creditworthiness as the company piles on more loans without increasing the ability to generate more income. Fitch Ratings, one of the many corporate credit rating companies similar to Moody’s Investor Service and S&P Global, downgraded Boeing’s credit rating to BBB- from BBB, which puts the company’s debt pretty close to the junk bond category. To appease lenders who are more risk-averse than equity investors, Boeing is offering an increase in 0.25% interest owed for each rating cut coming from either Moody’s or S&P Global. This is a big deal because the more interest piles up, the less capital returns to shareholders.
Boeing 10-Q Statement of Operations
We can see that Boeing’s interest paid to lenders has more than doubled $1.5 billion compared to $643 million the year before. As Boeing continues to borrow more, this figure will only increase. If Boeing’s credit is downgraded, the increase will accelerate.
Thus far, we have seen a 66% decrease in dividends paid to shareholders and a total cancellation of the share repurchasing program this year, even at the 50% discount. The ability of the company to return capital to shareholders will likely only continue to trend downwards. Rational market participants will abandon these stocks, and Boeing is currently cheap for a reason.
The bet I ended up making with my friend was speculation on both our parts on Schlumberger(NYSE: SLB) heading into earnings. He thought the shares were underpriced, and a better-than-expected earnings report would drive the stock price up quickly.
- SLB develops products for the mining/drilling/oil fields and has more diversified revenue.
- EPS beat over the last 4 quarters, likely to beat again.
- The stock price is down over 50% YTD.
- EPS will likely beat but means nothing since management indicating advanced cost-cutting already by gutting the workforce.
- Revenue likely will miss because drilling companies are so financially and operationally levered by debt. Most of them stopped operating the moment crude dropped below a certain threshold because the meager earnings generated on thin margins would only go to debt holders.
- Without the prospect of revenue growth, cost-cutting isn’t enough to return capital to shareholders. It’s more likely shares will slide on a revenue miss.
Our horses in the race
To make sure we had ample skin in the game, we both bought roughly at-the-money options. He bought call options on the bullish bet, and I bought very short-term put options for a leveraged bearish outcome (not recommended).
His call options with $990 at stake
My put options with $600 going the other way
Luckily for me, things ended up playing out in my favor, and on 10/16, SLB closed at $14.97, netting roughly $650 for my short position.
I am getting the Apron ready for him.
I want to note that this was speculative for both of us, and our story is not intended to state that I can predict future stock movements. Rather, the allegory illustrates how some basic understanding of fundamentals can help guide our investment decisions to be right more times than wrong.
For these reasons, I highly encourage every emerging investor to take the time to learn about financial statements, how companies operate, and how professional investors on Wall Street view businesses. Because more often than not, it will be Wall Street that has enough capital to move markets either in our favor or against.