STOCK MARKET DECLINES: DISTINGUISHING A GOOD DECLINE FROM A BAD ONE
Volatility can be very helpful, especially when it provides an opportunity to buy a stock with solid fundamentals at a low price.
Sometimes a drop in a stock can be explained by a small profit warning, especially if it is inflated by chartist traders and not justified by the fundamental position of the issuing company.
A possible 5% drop in a company's results, for example, does not mean that it is going to file for bankruptcy, since it can still make profits despite the drop.
This development is normal and can be caused by changes in business and operations, investments made by the company, among other factors.
Unfortunately, overreactions in the stock market are a reality, especially in the context of a bear market in general. The situation can be serious when structural causes are at the root of the decline.
Below are two illustrative examples, one of which represents a decline in a stock after a deterioration in the fundamental position of the company. The second has to do with the viability of the internal situation.
1. The case of Vallourec stock
Vallourec is a French company whose core business is the production of seamless pipes used in the oil and gas industry.
The oil and gas energy sector has been in crisis since 2014, with prices dropping significantly to their lowest level in 2016. Despite some recovery, they remain below pre-crisis levels.
Vallourec has been affected by this situation in the form of lower sales and profits since 2014. Perhaps things will change with rising oil and gas prices, which will allow for more orders and profits.
Unfortunately, this scenario does not seem to be for today, as the oil and gas business is cyclical and long-term.
Over a 5-year period from 2013 to 2018, Vallourec's share price fell from 25 euros to 2 euros, losing 92%, putting the company in bankruptcy.
What do Vallourec's fundamentals say?
In terms of fundamentals, Vallourec's sales fell sharply from €5.7 billion in 2014 to €3.8 billion in 2015, then to €2.96 billion in 2016, before recovering to €3.75 billion in 2017.
The company's results have trended downward since 2014, when the result was €923 million, then fell to €865 million in 2015, then to €758 million in 2016 and to €537 million in 2017.
Between 2014 and 2017, the company's equity decreased by 35%. Thus, it was €3.75 billion in 2014, fell to €2.65 billion in 2015, then rose to €3.28 billion and fell again to €2.43 billion in 2017.
Solvency ratios, which are derived from the ratio of financial debt to equity, only confirm the critical situation of the company.
In 2014 the ratio was 71.8%, in 2015 it was 81%, in 2016 it was on the threshold of 78.4%, and in 2017 it was 105.4%. The question now is whether the drop in the stock price is justified.
The industry crisis has hit Vallourec hard, and the stock price is struggling to recover despite the improving trend. The company's sales have plummeted, and the company has been suffering losses since 2014.
In fact, over four years, the cumulative loss was 3.08 billion euros. Equity is declining, and the solvency ratio exceeded 100% during 2017. These fundamentals are well explain the drop in Vallourec's share price, which lost 92% between 2013 and 2018.
What do Vallourec's fundamentals say?
In terms of fundamentals, Vallourec sales fell sharply from €5.7 billion in 2014 to €3.8 billion in 2015, then to €2.96 billion in 2016, before recovering to €3.75 billion in 2017.
The company's results have trended downward since 2014, when the result was €923 million, then fell to €865 million in 2015, then to €758 million in 2016 and to €537 million in 2017.
Between 2014 and 2017, the company's equity decreased by 35%. Thus, it was €3.75 billion in 2014, fell to €2.65 billion in 2015, then rose to €3.28 billion and fell again to €2.43 billion in 2017.
Solvency ratios, which are derived from the ratio of financial debt to equity, only confirm the critical situation of the company.
In 2014 the ratio was 71.8%, in 2015 it was 81%, in 2016 it was on the threshold of 78.4%, and in 2017 it was 105.4%. The question now is whether the drop in the stock price is justified.
The industry crisis has hit Vallourec hard, and the stock price is struggling to recover despite the improving trend. The company's sales have plummeted, and the company has been suffering losses since 2014.
In fact, over four years, the cumulative loss was 3.08 billion euros. Equity is declining, and the solvency ratio exceeded 100% during 2017. These fundamentals are well explain the drop in Vallourec's share price, which lost 92% between 2013 and 2018.
Although the company's current position is worrisome, a recovery in the oil and gas sector could change the situation by increasing its order book for pipes, which would have a positive impact on the company's sales and results.
A positive change in Vallourec's fundamentals would boost its share price.
If the oil and gas sector does not recover in the short to medium term, Vallourec's losses will be greater, which could lead to the need for capital restructuring or even bankruptcy. Either way, shareholders will incur net losses.
2. The case of EDF stock
EDF is a company specializing in electricity generation, distribution and sales. The company owns 58 nuclear reactors, 34 of which are 900 MW, 20 are 1,300 MW and 4 are 1,450 MW.
The company generates 62,400 MW of electricity from nuclear power. It is also involved in renewable energy, generating 21,900 MW of electricity from hydropower plants, which is 35% of its production from nuclear sources. While 2,200 MW comes from solar and wind power.
EDF is becoming a European leader in developing and storing electricity to optimize energy efficiency. This is the result of a quarter-century of investment in R&D.
Between late 2013 and early 2016, EDF's share price fell 65.5% from €25.40 to €8.75.
Since then, however, there has been an improvement, as the current share price is €14.51, although it is still 42.9% below its November 2013 level. But is this drop justified by the company's fundamentals?
If we look at the turnover achieved by EDF, in 2014 the company generated €73.38 billion. In 2015, this amount increased to €75 billion.
The following year, there was a decrease to €71.20, and in 2017, the company's turnover was €69.63 billion. Overall, the turnover decreased by 5.11%.
The results achieved by the company vary from year to year. In 2014, the company made a profit of €3.70 billion; in 2015, profits fell sharply but remained positive in the range of €1.18 billion.
A recovery occurred in 2016 with a profit of 2.85 billion euros, to continue the upward trend in 2017 with a profit of 3.17 billion euros. The 2015 performance is due to an exceptional impairment of assets in the U.K.
In the case of the Edison subsidiary, the impairment is more related to accounting charges than to actual expenses.
EDF equity also changed between 2014 and 2017, achieving a 17.5% increase. Equity was €35.19 billion in 2014, to regress slightly in 2015 with €34.75 billion.
The downward trend will continue, but to a lesser extent, in 2016 with a total of 34.44 billion euros. In 2017, equity will increase significantly and reach the threshold of 41.36 billion euros.
As for the solvency ratio, it is quite high with a clear improvement between 2016 and 2017. For starters, the ratio was 149.4% in 2014 and rose to 173.8% the following year.
The upward trend will continue in 2016 with a ratio of 189.3%, followed by a significant decline in 2017 with a ratio of 137.4%.
Between November 2013 and February 2016, EDF's share price declined, but is this decline justified?
The EDF business sector is characterized by stability, given that electricity is considered a primary need. Such a sector cannot experience a crisis because other expenses can be deferred or reduced, but not those related to electricity consumption.
The -65.5% decline in the share price from 2016 to 2016 is not related to the company's fundamentals, especially since the company has remained profitable, with an increase in equity and therefore shareholder value, not to mention that turnover has stabilized.
After the low point reached in February 2016, which was 9 euros, the EDF share price rose and reached a threshold of 14.51 euros at the end of November 2018. The main challenge for EDF is the government electricity price framework, as well as a somewhat high solvency ratio, which improved significantly in 2017.
Shares are characterized by their volatility, they move up or down according to economic and stock cycles. The price of some stocks tends to decline as the fundamentals of the respective companies deteriorate.
This may be due to a crisis in the industry, accumulated losses, especially high debt levels during a recession, falling stock prices, etc.
But sometimes financial markets can punish certain stocks for no apparent reason at a time when a company's economic situation is good. What is the reason?
There are a number of reasons why a stock price may fall when a company and its business are doing well. These include, for example, the announcement of a 3% profit warning.
This can cause the stock price to fall by more than 20% at a time when the change in profits is small and solely due to exceptional expenses. Such a phenomenon can gain momentum thanks to chartist traders.
The second reason could be a landing wave during bear market cycles. During stock market crises, there is no distinction between companies with good or bad fundamentals.
Fundamentals cease to have an impact during these periods, which, however, are temporary, even if they sometimes last several years. Shares of companies with good fundamentals then rise sharply, as they did in 2009.
The third reason has to do with fake news, which aims to destabilize the stock prices of the companies targeted by the fake news.
Such scenarios can be a source of disappointment for investors investing in companies with good fundamentals.
In such situations, it is important to step back and be patient until the markets become more reasonable and choose to diversify the portfolio to reduce risk.
Investors with cash can take advantage of these low-cost investment opportunities, as long as they carefully examine the company's fundamentals.
A good analysis of earnings, their stability or growth in recent years, profit margins, and balance sheet valuations, among other indicators, is highly recommended.
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