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To follow up on Monday’s post analyzing my prediction of an earnings beat for MEMC Electronic Materials, we’ll take a look at the first stock I bought using the strategy I discussed in “Picking Earnings Beats“, J. Crew. This post is meant to both reinforce my arguments for my aforementioned earnings beat strategy and to serve as a cautionary post for those thinking of using the earnings beat strategy for a longterm portfolio.
I found J. Crew earlier this year after looking around for potentially explosive growth from retailers. For those who haven’t read my post on the merits of investing in retail stocks, visit my Curious Investments, my blog over at NestEggr. Or, just read this post on the outperformance of retail stocks. J. Crew fit the bill as the next big clothing retailer. Heck, it even has Mickey Drexler, the man responsible for the growth of Gap in the 90s. Earnings growth since the company’s re-IPO after being taken private by Texas Pacific Group had been stellar and several months of flat movement had brought the company’s P/E to a bare premium over comparables in the industry - Abercrombie and Ralph Lauren in particular. Here’s what I saw upon looking at the charts this past summer.
The chart you see is 7/1/2006 - 7/1/2007. The numbers listed correspond to a “story” for this stock much like I marked off in the previous analysis of MEMC Electronic Materials.
1.) The stock IPOed to much fanfare right around July of 2006. Mickey Drexler had been at the helm for several years and turned the company’s product mix around and the timing of the IPO could not be much better as J. Crew was primed to finally begin turning profits. The stock ascended swiftly until December at which point it seemed investors cooled off.
2.) The stock entered its basing period around December of 2006 and traded in a roughly flat region for nearly six months. I found the stock about halfway through this period. Interestingly enough, despite the less than bullish stock movement, earnings numbers continued to come out strong and guidance continued to be favorable. Seeing a stock trading in the 20-25 PE range with EPS growth in the 30+% range, I knew this could be a big opportunity especially with the chart setting up bullishly. I bought.
3.) On May 31st, J. Crew announced its best quarterly earnings yet with well over 40% year over year growth, tremendous same store sales, and an upward adjustment of its 2007 guidance. The stock gapped up over 10% and began a short run setting all-time highs nearly every day for two weeks.
Unfortunately, macroeconomic events and market wide fear over recession and declining consumer demand perked up just as J. Crew’s stock seemed poised to take off. I’ve circled what looks like a decidedly bearish movement in July of this summer and below is the ensuing performance of J. Crew’s stock.
As you can see, the stock coughed up man of its gains dropping back to the baseline level set by its previous base. It would seem that J. Crew’s recent earnings performance was still not enough for the market to allow it materially higher baseline valuation and, instead, the wild appreciation following its tremendous earnings report at the end of May was but an over-exuberant response. This is the risk you run by looking for stocks that have industry and market beating earnings growth. These stocks achieve appreciation not only through fundamental improvements in their value be it asset value or earnings power, but also through multiple expansion as a result of ever increasing expectations. This also means that expectations and not fundamental value drive their share price and, thus, the stocks are likely to be more volatile especially in a market environment as tumultuous as we’ve seen in the last few months where market participants have no idea what to expect.
What is seen in this example is that one can successfully invest to pre-empt base breakouts based on expected earnings performance provided you understand the fundamental drivers for the business’ success. The earnings beat strategy, however, is ultimately just another market timing strategy albeit one which favors quality, growing companies at reasonable (not necessarily discounted) valuations. As with any market timing strategy, one ought to expect return in a short time frame and not be afraid to sell to reap reward. In the case of my buy on J. Crew, a proper sale would have netted a 35%+ gain within three months. Subsequently, while earnings performance has continued, market conditions have deteriorated and, six months after my purchase, J. Crew is now trading at break even prices to my purchase price.
In my case, the fundamental research that I have done on the company keeps me confident of the stock’s longterm performance. At this point, the technical analysis and market timing strategies employed were helpful at the onset, but ultimately of little use to whatever returns are eventually made on this position. Long story short, the earnings beat strategy can work, but, as with any investment strategy, understand how it works within your individual time horizon, risk profile, and investment competencies.
Speaking of which, for those looking for further tips on market timing particularly on sell strategy, stay tuned as I have quickly realized that this case study is a quintessential example of how to time a sell.
Full Disclosure: If you can’t tell already, I’m long shares of J. Crew. For a list of all my holdings please visit the My Stock Holdings page.
November 15th, 2007 at 11:13 pm
JCG is a pretty good story. The company seems to do well with inventory levels and seems to be well managed. It will certainly have its lows, but JCG looks like a good growth story.