The market does not always act rationally. When a company becomes a market favorite, investors tend to pile in and drive the stock price way above any reasonable valuation. And when a favorite struggles, the market punishes it in the other direction, driving down the stock price below where it should be.
Savvy investors have known about these market predilections for years, and take advantage of them.
I think lululemon athletica (LULU), the Canadian designer, manufacturer and retailer of yoga and other trendy athletic-oriented women's wear, is an example of the market taking a former favorite and sending it flat down onto the yoga mat. If the company can generate some good news -- and I think there is a reasonably good chance that it can -- then the stock could rise up from its current downward-facing dog pose to a full upright tree pose.
I am not alone in this opinion. My colleagues at TheStreet, Jim Cramer and Stephanie Link, recently endorsed lululemon.
But first, let's be honest: The company must get over some significant hurdles. Quality control problems, such as overly sheer yoga pants, caused multimillion-dollar write-offs and hurt the company's reputation. Management turmoil, including controversial comments from its outspoken founder, Chip Wilson, who has stepped down from his CEO position and sold half of his stock position, caused more havoc.
Competition is fierce. The Gap (GPS) has a competing retail chain, Athleta, and V.F. Corp. (VFC) has its lucy brand. Companies such as Nike (NKE) are also making clothing similar to lululemon.
That said, as Stephanie Link remarked during an interview with TheStreet's Jill Malandrino, the company has a lot going for it. Its stock, recently trading at about $45, is bouncing on the bottom; it topped $80 as recently as June 2013. This limits the potential downside. The company is well positioned to take advantage of the health and wellness trend, and athletic apparel is a very hot area today. New management, which has invested heavily in improving performance and to iron out the kinks in its supply chain challenges, are additional pluses. These efforts should start paying off soon.
Just as the stock was clobbered on bad news, good news should provide a magnified uptick, given Wall Street's low expectations. The likelihood of a rebound is further supported by analysis from my Peter Lynch-based strategy, which mirrors how the legendary investor picked stocks.
This strategy focuses on the P/E/G ratio, which is price-to-earnings relative to growth, and is a measure of how much one is paying for growth given the stock's current price. lululemon's P/E/G is 0.65, well below the 1.0 maximum allowed under my strategy. The stock looks well priced. Further supporting the thesis that now is a good time to buy: The company has zero debt.
You do not need the flexibility of a yogi to see this company's potential. A turnaround situation is always risky, but the risk-reward ratio looks favorable.