How to Profit From Market Overreactions

We are mostly through third-quarter earnings season, although numerous small-cap concerns are still on tap to post results. Some of my best investment opportunities come during reporting season. Most involve overreactions on quarterly misses. In an age where over half the trading volume is driven by myriad trading programs and algorithms, I find knee-jerk reactions are more the norm. Sometimes I think the bots are controlling a good portion of trading based on headline numbers, not even bothering to read through the earnings transcripts. This presents a lot of good opportunities for those who are willing to do the work to find stocks that have been taken to the woodshed when they probably deserved a slap on the wrist. The way I like to take advantage of these opportunities is by initiating or adding to holdings and by employing buy-write option strategies using call strikes near the current trading level of the equity. Usually I utilize calls with expirations six to seven months out. This provides a decent amount of downside protection and can lead to 15% to 20% potential returns if the stock does little but stabilize during the option duration. I particularly like employing this strategy with names that have solid cash flow even as headline earnings and/or revenues might have been disappointing. I covered one such name in Supernus Pharmaceuticals Inc. in my column pn Wednesday. Shares of Supernus fell about 35% that day on its third-quarter miss, which it reported pre-market. Taking out the huge amount of net cash on the company's balance sheet, you get a free cash flow yield north of 20% for fiscal 2019 on Supernus. I added to my holdings under $20 late Wednesday. The stock bounced back about 6% on Thursday. Another name I added to late Thursday was TPI Composites Inc. , which makes composite wind blades and related precision molding and assembly systems for original equipment manufacturers. TPI's stock was off 25% in trading Thursday as the company posted a third-quarter loss of 13 cents a share. The consensus had it breaking even. Revenue came in slightly under expectations as well, although it should be noted sales did increase about 50% over the same period a year ago. Anyone who read the earnings transcript would realize that management did slightly lower full-year revenue guidance but kept all other guidance as it was. In addition, TPI saw a big increase in EBITDA on a year-over-year basis. The company also generated a large amount of cash from operations in the quarter and has about $40 million more cash than debt on its balance sheet. Yes, the trade war with China is impacting TPI. However, it has thrown off more than $60 million in cash flow from operations through the first three quarters of the year. With a market cap of less than $570 million at present, that is a big cash flow yield. The stock currently goes for around 40% of annual revenue as well. This should put a floor under the stock while TPI continues to post revenue increases and waits for sentiment and fundamentals in the space to improve. I think both of these names will be higher six months from now. However, even if they are dead money, I am set up to pocket some nice pocket change by buying the dip produced by the overreaction in the market using my covered call strategy.

How to Profit From Market Overreactions

A look at Supernus Pharmaceuticals and TPI Composites provides a tutorial on reaping rewards from stocks the market suddenly hates.

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