How to Profit When Mr. Market Goes Too Far

Just as investors can create technology stock and real estate bubbles, Mr. Market can also hammer away at specific companies when they experience bad news. While a downward stock price movement after negative news is often justified, there are times when markets overreact, creating potential buying opportunities.

One historical example that comes to mind is  Biovail , which lost 25% of its value in one day in the summer of 2006. The stock dropped on a court ruling that essentially accelerated generic competition for one of the company's biggest drug offerings. However, the company's patent was due to expire within months anyway, and the hundreds of millions in market capitalization the company lost were well above the expected loss from a few extra months of competition. Roughly four months later, the stock was back trading at its price prior to the sell-off. So how can you find more of these opportunities, and how can you determine if the market's reaction is a potential overreaction?

There are many different ways to source investment ideas. Morningstar's  Premium Stock Screener is a great tool to find potential investments that meet certain criteria. You may want to consider a stock screen that looks for 5-star stocks that have lost at least 25% of their market value recently. For our purposes, we will use the year-to-date period. To run the latest version of this screen yourself,  click here. Our goal with this screen is to pinpoint a drastic market decline. Then we'll look to tie that decline to a specific event for which we can quantify a value.

Once we have found stocks with a 25% decline, we need to look through the performance charts of these stocks and look for a sharp decline, as opposed to a long-term, gradual sell-off. After we find a sharp decline, we need to find the news event that caused the stock's sell-off. We must be careful not to stop at the first piece of news we see, as there could potentially be multiple reasons why a company's shares have plummeted. But once we are able to link a company's decline to a specific event, we can then look at the impact of that event on the company's fundamentals. In the case of Biovail, it was easy to see that the potential sales losses from its largest product were still less than the drop in the company's market capitalization. We could look at the projected sales for the drug from the time of the court ruling until the time of the original patent's expiration date and then make a few assumptions as to how much market share a generic competitor could steal in that short period. Since the market decline was clearly more than the expected impact from the court ruling, one could determine that it was an overreaction. It is important to remember, though, that other circumstances could be more subjective and less quantifiable than this example.

One company that our screen produced was  Jackson Hewitt . In January, the stock dropped from roughly $32 to $24 per share in one day. The stock continued to decline over the next eight weeks to $20. The initial drop came on news that the IRS was looking into refund anticipation loans (RALs), as we discussed in  our note on the topic. Consumer advocacy groups frequently complain about RALs, which represent a significant portion of Jackson Hewitt's revenue and earnings. However, the IRS does not have authority to ban RALs (as one news article suggested it was considering) and previous complaints have had little impact on the industry in the past. Valuing this event was a more subjective exercise, but our opinion was that this event would have little impact on the industry and a 30% price drop was unwarranted.

Already on shaky ground for the IRS issue, Jackson Hewitt was again hammered after a slow start to the tax season. The stock declined in early March from $20 to $14, eventually reaching a low of $11. While the decline in customers did impact our assumptions, reducing our fair value estimate, this was once again too drastic of a market reaction, in our opinion. The price immediately following the earnings release implied that the company would lose almost one third of its customers in the coming years, which we see as an extremely unlikely scenario. The stock has rebounded and currently trades at $17, almost half of our fair value estimate. While our initial fair value estimate was too optimistic, given the lack of growth experienced in the 2008 tax season, our above-mentioned strategy would have initially put this stock on your radar at a price that is only slightly above our current Consider Buying price of $22.50. See our full  Analyst Report.

Keep in mind that while there may only be a short period of time where such a mispricing takes place, we still want to think long-term and invest in stocks that are undervalued as a whole--hence the 5-star criterion in the screen. Also, both stories above demonstrate that buy and hold doesn't mean you can just buy stocks and walk away, never looking at them again. Had you purchased Biovail's depressed shares, you would have seen the stock plummet again a year later. This time, the drop would be the result of something completely different: a rejection of one of its products by the Food and Drug Administration and a complete shift in the company's strategy. Remember that even though you may have evaluated a piece of information to which the market is overreacting, it doesn't mean that new information won't come out in the future and change the picture.

Stay tuned for more ideas using this strategy. In the meantime, you may want to hunt for ideas of your own by checking out some of the other 138 stocks that popped up in our screen.