When it comes to stock picking, there are two primary schools of thought. The first, and by far most popular, school believes in selecting stocks based on strength. These investors buy breakouts, bullish signals, and uptrends.
The second school teaches to look for price weakness when selecting stocks. Following the age-old mantra of buying weakness and selling strength, these investors love finding stable stocks that have been pushed lower.
Both these strategies have their place in a successful investor’s quiver of tactics. However, one beats the other when it comes to stock selection for the long term.
Buying weakness, not strength, is the key to success for long-term investors.
It all goes back to buying long-term value that is created when a solid stock dips in price. Remember, value and price are two different things, and when the price falls, it can create an opportunity to buy value at a discount.
A Winning Value-Finding Tactic
My favorite way to buy weakness is to scan for stocks with “gap downs” on the daily chart.
Gap downs, which occur in a stock’s price chart when the price jumps down with no trading between, are usually caused by investors dumping shares on bad news. These investors overreact en masse to short-term bearish factors, pushing prices down so quickly that a gap appears in the stock’s price trend line. Stocks that had been in strong uptrends and gap down are likely to return to the upward trend thus make excellent buy candidates.
There are three crucial metrics that must be followed when buying gap-downs to maximize your odds of success.
First, look at the price. Make sure there isn’t something permanently toxic about the company. Ideally, you’re looking for a short-term negative catalyst that has resulted in the gap down. See if there is corresponding positive news that panicking investors may have overlooked.
Secondly, only buy gap downs that remain above their 200-day simple moving average. Of all the technical indicators, institutions and big money players are well known for placing the most emphasis on the 200-day simple moving average when making investment decisions.
It is the one indicator that identifies long-term trend. If the price is above the 200-day simple moving average, the long-term trend is up. Before you make a decision, use this method to confirm the long-term uptrend of the beaten-down stock.
Lastly, I like to see some strength in the share price before buying. Waiting for a bounce off the recent lows is a smart way to enter trades.
Now that we know how to buy weakness, here are three beaten-down stocks that have set up to be great investments.
1. Eaton Corporation (NYSE: ETN )
The $33 billion power management company has fallen off its uptrend, setting up great buying opportunity.
ETN climbed from around $45 per share to over $80 from January to mid-July 2017. Then the price started slipping in anticipation of second-quarter results.
When these numbers, which showed lagging revenue for the quarter, hit the newswire, shares went spiraling lower. The price gapped from $78 all the way down to $71.50. Shares have since stabilized in the $72-73 range.
This was all based on a slight earning miss: earning per share ( EPS ) were $0.01 lower than expected and revenue was $10 million lower for the quarter.
What these quickly-triggered investors did not consider is that the company also posted net income and operating earnings up 7% and provided guidance at the high end of the range for the third quarter.
Buy ETN on a breakout above $74 per share and hold for the long term.
2. Cummins (NYSE: CMI )
Here’s another great example of a gap-down buying opportunity. This $27 billion manufacturer, distributor, and servicer of diesel and natural gas engines soared from $144 in April to over $170 at the end of July.
However, the share price saw a gap-down all the way back to the $154 zone on a second-quarter miss.
Shares have since stabilized to around $160. Investors must have realized that 2017 revenues are projected to be higher by 9% to 11%, nearly doubling the previous forecast in the 4% to 7% range.
Buy now close to $160 and hold for the rebound.
3. Glatfelter (NYSE: GLT )
The $777 million paper and fiber maker reported a nearly $6 million second-quarter loss. Investors panicked, sending shares down to support in the $17 zone.
The company’s loss was due to weakness in the specialty paper market. But at the same time, the company saw robust growth in its shipping volumes and engineered materials businesses during the quarter.
Glatfelter shares have stabilized, but it is not signaling a buy just yet. Wise investors will wait for a move above $18.50 per share to enter long.
Risks To Consider: Gap-downs can provide incredible buy opportunities. However, gap-downs can sometimes continue lower, even after exhibiting price strength. Always prepare for the downside by using stop-loss orders. Place them just below the support level of the price gap-down.
Action To Take: Consider adding one or more of the above stocks to your portfolio. Scan for additional stocks suffering from gap downs to find real value in the market.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
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