Breaking Stories

How to tell if a company’s business is in trouble, or just its stock

Broken stock, or broken company? That’s the question that every investor needs to be asking themselves following Thursday’s Consumer Price Index report, which showed a steeper rise in inflation than expected and triggered yet more market volatility. The news essentially ensured the Federal Reserve will hike interest rates by another 75 basis points next month, while doubling the odds of an additional rise in December. In this environment, nobody could be blamed for wanting to simply liquidate their holdings and sit in cash until the Fed succeeds in breaking the back of inflation. However, as we discussed during our “Monthly Meeting” Thursday , the problem isn’t getting out of the market. That’s the easy part, and you could do it now with relatively high confidence that there isn’t a reason for the market to go up meaningfully and sustainably any time soon. But the hard part is knowing when to get back in. The market tends to sniff out news and make moves before that news is widely known. So, by the time you get the ‘all clear’ signal, you’ll have more than likely missed a good deal of the bounce back. That’s why we told Club members on Thursday that we’re not folding our hand. We believe it’s far better – and less risky – for a long-term investor to run a diversified portfolio with cash on hand, opportunistically readjusting based on the data and prices the market throws at you. We say “less risky” because unless you’re a professional trader (and even then your edge may not be what it once was before algorithms took over) trying to hop in and out of the market requires being right not only about the company in question, but also in your timing. Moreover, that type of market participation will require your full-time focus. Crucially, trying to hop in and out based on data like a CPI report is going to push your emotional control to the limit – and that’s half the battle when investing in equities. Stocks fell Thursday on the back of the CPI data, before later staging a rebound in afternoon trading. The S & P 500 was up nearly 3%. So, if we’re not going to fold our hand, then what? That doesn’t mean we simply pile in. Instead, knowing that there is no rush to get in at the moment, what we want to be doing is scanning for broken stocks of still-strong companies. Now, when we say still-strong companies, that applies to their financial position and ability to weather an economic downturn, as well as their longer-term earnings power. The former is easily determined by reviewing financial statements, as we recently outlined. The latter is a bit more abstract and will require one to think about the business in question qualitatively. For example, a company may have a strong balance sheet at the moment, but if consumer preferences are shifting in a way that could result in less demand going forward, longer-term earnings power may be negatively impacted. Club holding Meta Platforms (META) is a perfect example. A debate is currently raging as to whether the tech giant is a broken stock or a broken company, with shares down more than 60% since the start of the year. Some will argue it’s a business in decline, led by a CEO who has taken his eye off the ball. And, as a result of increasing competition, its share of the advertising market and social media users is at risk. If that’s your perspective, then you’re more inclined to view Meta as a broken company and, therefore, untouchable. If, on the other hand, you believe that Meta management is investing in the future – as we do – and that they will do with Reels what they did with Stories (fend off the competition and increase engagement and monetization over time) on their platforms, then you would likely think that longer-term earnings power and cash-flow generation will bounce back. In that case, what we have here is broken stock, not a broken company. Other cases may be more clear cut. Take our recent case study of AMC Entertainment (AMC). The financial positioning is dire, and consumers are clearly forgoing expensive outings to the movies, opting instead for an at-home streaming experience with their snack of choice at a supermarket price. Given the financial position and demand dynamic, that doesn’t bode well for the topline. AMC is clearly a broken company – at least for now. Of course, once you’ve determined whether you’re looking at a broken stock or a broken company, the next step is to consider valuation. As we’ve said all year, no matter how grand the promises are from management, what we want are real profits, in cash. Given that, we’re focused on earnings-based valuations (price-to-earnings). Additionally, we have to acknowledge that any estimates we look at right now may still be too high given today’s CPI print, the expected reaction from the Fed, and the simple fact that the analysts making these estimates have been behind the curve the entire way down. Therefore, you want to be even more strict on the valuation you are willing to pay for anything. That’s one of the reasons we opted to forgo our intended purchase of more shares of Linde (LIN) stock on Thursday, something we discussed during the monthly meeting. When we were debating the move, shares were down $1, however, by the time we decided it might be right to pull the trigger, the stock was up $8 – and this is not a market in which you can afford to chase. Ultimately, we’re in a brutal market. There’s no denying that. But rather than try and hop out and then be forced to time the exact right moment to jump back in, we feel the best course of action is to simply maintain a diversified portfolio of high-quality companies. And, at the same time, we’ll continue to search for the broken stocks with resilient earnings power. (Jim Cramer’s Charitable Trust is long META, LIN. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust’s portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

Federal Reserve Board Chairman Jerome Powell speaks during a news conference after a Federal Open Market Committee meeting on January 29, 2020 in Washington, DC.
Samuel Corum | Getty

Broken stock, or broken company?

That’s the question that every investor needs to be asking themselves following Thursday’s Consumer Price Index report, which showed a steeper rise in inflation than expected and triggered yet more market volatility. The news essentially ensured the Federal Reserve will hike interest rates by another 75 basis points next month, while doubling the odds of an additional rise in December.

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