It’s the conundrum every investor — and every momentum investor –must face. When a stock is on a tear, do you jump in?
Isn’t there a higher degree of risk to buy into a stock that has been performing particularly well as of late? How do you know if you will be the victim of a reverse in momentum? I certainly have enough bad memories of the dot-com bubble bursting and watching certain stocks go almost to zero.
The key with this approach is to recognize whether the stock is going higher because the market finally realized it was undervalued and is paying catch-up, if the story continues to improve such that earnings continue to grow, or if the price has outstripped any sense of rationality purely due to momentum trading.
Here are three stocks I think have room to run, even after their strong moves, because of business fundamentals.
My mind immediately jumped to pharma outfit Forest Laboratories (FRX), but it has been acquired by Actavis (ACT). But that’s OK. ACT stock has been on quite a tear itself, having tripled over the past two years. It has been on an acquisition binge, and Forest was just its latest addition.
Forest’s EPS, balance sheet and cash flow were outstanding, so ACT definitely got itself a catch there. Actavis’ financials are fantastic, with adjusted Ebitda having increased almost 60% in FY13, and more than doubling year-over-year in Q4.
Combined, these two powerhouses have more upside. ACT stock has 45 branded pharmaceuticals and hundreds of generics. Forest has numerous pharmaceuticals, of which Lexapro is probably the most well known.
ACT is up more than 30% YTD. It will go higher.
Southwest Airlines (LUV)
I hate airline stocks, but I have a hard time admitting that business and consumer travel is not booming. Hotels and online booking companies are going gangbusters. You can’t get to a hotel unless you travel there, and that means either you’re driving or you’re flying.
LUV stock also has tripled since late 2012, and somehow an airline stock has more cash than debt ($3.5 billion to $2.2 billion). Oh, and somehow an airline stock also has free cash flow of a billion dollars.
That’s why I think LUV stock continues to move higher, even more than the 46% YTD.
Delta Air Lines (DAL) is another such “what am I thinking?” stock. It’s up 46% YTD, and again, I just point to the travel boom. I also point to the consolidation in the industry, which means there’s less supply to meet consumer demand, which leads to higher prices. I would be careful with Delta, though. While FCF was strong last year at $2.5 billion, it carries $9 billion in debt. If we get a terrible GDP number for Q2, people might cut back on travel after the summer ends. In that case, get out.
Electronic Arts (EA) somehow has survived, and thrived. I wrote in late 2011 that EA was facing some challenging competition, and that, “It’s a “buy” for aggressive investors, while others may want to wait for a pullback to increase their margin of safety.” If you were aggressive and listened to me, you have a 140% return.
EA stayed on top of its game, so to speak, and is now growing EPS at a 23% long term rate according to analysts. Earnings for the period ending in March of 2015 are expected to be $1.89 per share, meaning fair value is somewhere around $43. The stock trades at $36.76, so there’s room to run. The balance sheet remains strong, with $1.78 billion in cash offset by only $580 million in debt. In fact, that’s $4 per share in cash, meaning the effective stock price is around $33.
As of this writing, Lawrence Meyers did not hold a position in any of the aforementioned securities. He is president of PDL Broker, Inc., which brokers financing, strategic investments and distressed asset purchases between private equity firms and businesses. He also has written two books and blogs about public policy, journalistic integrity, popular culture, and world affairs. Contact him at firstname.lastname@example.org and follow his tweets at @ichabodscranium.