Long term value investors react to news in one of two ways. If the news is negative, it should be fully accounted for in the analysis and valuation. If the news is positive, it should be treated as a potential bonus, and only in rare circumstances where the investor is nearly certain of the outcome and its effect should it be included in the valuation. Leave it to the short term traders to react to news!
Consider the case of Frequency Electronics, Inc (NASDAQ:FEIM), a designer, developer and manufacturer of equipment for timing and synchronizing satellite and terrestrial voice, video and data communication. On January 11th, the stock leapt 7% on news that the company had been awarded a follow-on contract with the US Government worth approximately $12 million. Indeed, this is good news for the company, and the fact that the company’s market capitalization rose by only $3.88 million (using the company’s P/E, this would represent an expectation of profiting $209,000 off the contract, which is only a 1.74% profit margin) one may be led into thinking the market had not fully impounded the profit potential from that one contract alone.
The key is to consider whether the company was overvalued in the first place. On an asset basis, it certainly was, given that it has an NCAV of $5.50, an a value investor would seek an additional 1/3 discount to that for a margin of safety. The company had been trading at $6.87, nearly 90% higher than the desired price. On an earnings basis, there is little to go on, as the company has a sketchy earnings history. Even adjusting for one-time expenses (which appear quite regularly), we get an average return on equity over the last decade of just 0.7%. On a cash flow basis, we see that the company had negative FCF in four of the last six years.
It would appear to me that the company was overvalued prior to the announcement, which would provide a reason as to why the company promptly fell 4% the next day – Mr. Market had already impounded an improvement in businesses into his expectations. Value investors are better to search for companies that the market believes have no future, as even slight wins on behalf of the company yield outsized returns. FEIM may have been such a company just six months ago, when it was trading in the mid $4 range!
Author Disclosure: No position.