On Monday we saw several stock-moving downgrades from high-profile firms. While many of these downgrades are warranted, some are following the leader of prior downgrades, and may create upside for the investor. Thus I am looking at the top downgrades to determine if any present value.
In my book Taking Charge With Value Investing (McGraw-Hill, 2013) I present a value-finding formula that I call (10-10-10) which has become very popular among the retail investment community. I have literally received 100s of emails regarding this one strategy alone, which explains that (in theory) a company should be fairly valued when bottom line growth, year-over-year stock performance, and P/E ratios all align, and then are favorable to the growth and valuation of the broader market. Of course this is a broad topic, but is important to valuing an established company such as AutoZone, Inc. (NYSE:AZO).
Deutsche Bank gives us a clear example of why this strategy works: The firm downgraded AutoZone, Inc. (NYSE:AZO) to Hold from Buy after saying its 13.34 times 2014’s EPS is greater than its now “fair value.” The firm points to the fact that it “typically” trades at 12.5-13 times earnings. After a year of trading flat (compared to the S&P 500 gaining 13.50%) AutoZone, Inc. (NYSE:AZO) has gotten cheaper while the broader market has gotten more expensive.
If the S&P 500 trades at 14 times 2014’s earnings with less year-over-year growth then the analyst is not properly valuing AutoZone, Inc. (NYSE:AZO) to the premium in the market. This would be the second part of 10-10-10 formula, as the stock is “historically” fairly valued but has not seen an increase in premium relative to the market. Therefore, while I don’t think a great deal of upside is present, I do say that with auto being strong, AutoZone could see 15-20% upside.
Ctrip.com International, Ltd. (ADR) (NASDAQ:CTRP)
According to Goldman Sachs, it’s time to take profits in shares of Ctrip.com International, Ltd. (ADR) (NASDAQ:CTRP), hence the firm cut shares to Neutral. The firm believes that its valuation of 18 times 2014’s expected earnings is too expensive for a company that is expected to see 20% EPS growth from 2014-2017 (per Goldman’s expectations)
Goldman is basically saying that Ctrip.com International, Ltd. (ADR) (NASDAQ:CTRP)’s 20% premium to the S&P 500 based on expected P/E ratios for 2014 is too expensive for a company growing nine times faster than the S&P 500. In an internet industry that typically trades at large premiums to fundamentals, this makes little sense. In my opinion, Ctrip.com International, Ltd. (ADR) (NASDAQ:CTRP)’s 20% premium and its nine times faster growth than the S&P is an indication of value, and although Goldman’s expectations for seasonality weak periods in Q2 and Q3 could create weakness, I do believe that Ctrip.com International, Ltd. (ADR) (NASDAQ:CTRP) is a long-term “buy” if the company maintains bottom line growth of 20%.
Alpha Natural Resources, Inc. (NYSE:ANR)
Alpha Natural Resources, Inc. (NYSE:ANR) has produced one of the greatest periods of loss in the market over the last five years. It has lost 88% of its value during this period, almost 50% during the last year, and 30% in 2013. Thus it has been a continuous downtrend for the stock. However, Standard & Poor doesn’t think it is over, as they lowered their outlook to Negative from Stable.
It’s hard to imagine that shares of Alpha Natural Resources, Inc. (NYSE:ANR) could trade any lower, but S&P expects continued weakness in coal and that pricing will continue to challenge the company’s operational conditions. S&P specifically notes trouble in Central Appalachian thermal and metallurgical coal markets.
While I don’t know the future demand for coal, I do know that Alpha Natural Resources, Inc. (NYSE:ANR) is globally diversified and that it’s highly vulnerable to the weakness of large markets. In its last quarter alone, sales fell 31% and its margins continued to worsen. To me, this doesn’t look like a company that is nearing the end of its decline, but is rather continuing to decline in a rapid manner. Therefore, I have to agree with S&P, and suggest that Alpha Natural Resources, Inc. (NYSE:ANR) is not a buy at this time.
Conclusion
In the market, downgrades often create opportunity. On Monday, there were two cases where I think investors could benefit from the post-reaction of a downgrade. In my book I discuss this topic in great detail, with one of the core lessons being to determine whether or not the reasons for the call are already priced into the stock. If a stock has been downgraded five times in six weeks for the same reason then chances are that its valuation is priced for the reason noted. Then, it becomes a question of valuation, and if the valuation is attractive relative to fundamentals and compared to the broader market, then you might just find yourself a golden opportunity.
The article Did Monday’s Market Moving Downgrades Create a Buying Opportunity originally appeared on Fool.com and is written by Brian Nichols.
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