The market reacts extremely quickly to new news. It moves so quickly, in fact, that you and I will never be able to make money by trying to move in or out of companies' stocks based solely on the headlines. By the time you digest the news, decide the right move to make, contact your broker, and order the trade, the stock's price will have already changed to reflect the new information.
Take Merck (NYSE:MRK), for example. On Sept. 29, 2004, its shares closed at $45.07. By the time the market opened the next day, its shares were at $33.40. That was a drop of better than 25%, literally between trades. The big news? The company had pulled its former blockbuster painkiller Vioxx from the market, after studies revealed that it looked to be potentially linked to heart problems.
The company's stock adjusted to the news so quickly that nobody was able to sell between the announcement and the fall. Anyone wanting out of Merck based on the Vioxx news had to sell at a far lower price than they could have received just before the announcement. It always happens like that, and there's really nothing you can do to get around it.
Your chance to shine
By the time news comes out, it's already too late to take advantage of it. What you can do, however, is set yourself up for what happens next. When a company stumbles as Merck did, the market has a tendency to overreact. Since its fall from grace, Merck has seen its shares completely recover to recently trade at $45.64. Include Merck's $3.04 in dividends over that period, and had you bought after the Vioxx mess, you would have seen a 45% positive total return in a hair more than two years. That's not a bad return for a company that had unexpectedly lost a multibillion-dollar product and still faces all sorts of lawsuits from it.
It's also the way these things often work out in the real world. Have you noticed how well Tyco (NYSE:TYC) has recovered since the Kozlowski scandal in 2002? How about Microsoft's (NASDAQ:MSFT) amazing returns since announcing more than $2 billion in unexpected investments to better compete with the likes of Google (NASDAQ:GOOG)? And who can forget McDonald's (NYSE:MCD) and its disastrous "Made for You" program? Apparently Wall Street can, based on how well McDonald's shares have performed since the company yanked the program in 2003.
Time and time again, the market's immediate reaction to bad news seems to be "shoot first, ask questions later." Of course, if a problem is going to absolutely sink a company, it's best to get out while you can keep some of your cash. If a company can and will likely recover, however, the aftermath of a meltdown is often the perfect time to buy.
Why this works
There's a simple reason why these meltdowns are often so severe. Every company has what we at Motley Fool Inside Value call an "intrinsic value." It's an estimate of the business' true worth that's based on its expected future earnings. Most of the time, most companies trade within spitting distance of their intrinsic values. When a shock to the system happens -- like a withdrawn major product -- that changes the reasonable expectations of that company's future earnings and, with it, its intrinsic value.
Yet until the story plays itself out over time, nobody knows exactly what will happen. As a result, the market tends to assume the worst and consequently prices in less growth and more risk to the affected company. Lower growth and higher risk translate directly to a lower stock price. As a result, a company usually winds up trading far below where it should be, even adjusting for its new, post-incident reality.
That's when you have the chance to beat the market -- after a fall.
At Inside Value, we've taken advantage of this behavior since our inception in 2004 to outperform the market. In addition to Tyco and Microsoft, our roster of current and former picks includes such nefarious beasts as MCI -- what was left of the former WorldCom. With a laser-like focus on intrinsic value, we're willing to buy the tattered remains of former glory stocks at bargain-basement prices, and that has given us the edge. You can see all of our recommendations for free with a 30-day trial. Join us today to get an early start on the next great recovery.
At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Merck and Microsoft. Tyco and Microsoft are Inside Value selections. The Fool has a disclosure policy.
