Even when there are wrinkles in the PE Gap approach (comparing a company’s earnings growth rate to its price-to-earnings multiple) matrix, there are still profitable strategies for playing its valuation model.
Case in point:Micron (NYSE: MU)
Identifying stock buying opportunities using the PE Gap approach can be challenged by short-term operating performance.
If a company sees a blip in its earnings, the market will often react harshly, punishing shares with a drastic price reduction.
In June, the PE Gap identified Micron as a potential stock to buy.
At the time, shares traded for a multiple of earnings that was far below its expected profit growth rate.
A slew of Wall Street downgrades and upgrades made for a stark contrast as the company headed toward its earnings report later in the month.
The market was voting on the bears as Micron shares plummeted.
The PE Gap, in this instance, was flawed. Though the model soars in the vast majority of cases, things can get quirky when there are issues with near-term operating results.
Micron faced such issues in June. When they reported earnings, the numbers were worse than expected and the stock fell another 20%.
Ultimately, we instructed our Millionaire Blueprint members to take their capital losses and move to the sidelines before the damage accelerated.
Our rules allow us to sidestep these occasional dramas that take place from time to time.
The question in late June was “do we reenter the position?”
It was tempting, as Micron’s long-term prospects compared to a new and even lower valuation were compelling, to say the least.
At the end of the day, we opted to seek opportunity elsewhere, but noted that enterprising members may wish to play a Micron reversal with longer-dated Call options at the beginning of July.
In the near-term, that looked like throwing good money after bad, as Micron shares continued their slump. Valuation trumps speculation, and Micron shares were moving beyond silly levels to absurd.
On Monday after the market closed, news came that Chinese chip-maker Tsinghua hoped to acquire Micron for the lowball price of $21 per share.
The market reacted on Wednesday by lifting Micron shares some 10%.
Those longer-dated Call options, if acquired on the first of the month, have now more than doubled in value, with more gains likely.
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