Thursday, July 30, 2009

Troughing Now Or Later?

During recessions, not all industries experience the pain (and the enusing recovery) at the same time. Some industries get hurt first, while others don't feel the ripple effect for several months. With Wall Street's over-emphasis on the importance of current earnings, understanding these cyclical troughs can help value investors profit.

Consider Hammond Power Solutions (HPS.A), a stock that has twice been discussed on our Value In Action page due to the fact that its price fluctuates far more than does its business value. In the last quarter of 2008, while banks and most companies related to the housing industry were struggling to meet their obligations, HPS reported record sales and profits, prompting its Chairman and CEO to state the following in late March of 2009:

"As our 2008 results illustrate, HPS has come through these challenging economic times relatively unscathed."

As a result, its stock price appeared to trade close to its intrinsic value in a pretty weak general market, as we discussed here. But fast forward four months, and it appears the company is all of a sudden experiencing a downturn. Net earnings dropped 87% year over year in the 2nd quarter of 2009. The Chairman and CEO has completely changed his tune, as evidenced by the following new statement on July 16th:

"Going forward, it is fair to say that the global economy is performing worse than even our most pessimistic forecasts of six months ago."

The stock price has of course responded to the current earnings environment for this company, rather than its long-term earnings power, as it is down over 20% in the last two months. If the stock continues to fall due to drops in demand that are of a short-term nature, it will once again provide the long-term investor the opportunity to purchase a good company at an excellent price! Buying companies that are in the midst of cyclical troughs is an excellent way to derive long-term profits*.

*The tricky part, of course, is ensuring a company is indeed going through a cyclical and not a secular downturn, and has a financial position and cost structure such that it can survive/thrive until better times return.

Disclosure: None

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