It is hard to admit, but sometimes markets act irrationally. We all love to think that every move is the result of a careful weighing of performance, possibility and profitability. That logical state satisfies some fundamental, deep seated need we have for order in our world. When we see a move that makes no sense on the surface, we tell ourselves that “somebody knows something I don’t;” that there is some vast conspiracy on Wall Street.
I felt that way yesterday as I watched the market reaction to the earnings release of Heico Corporation (HEI). Heico is in the aerospace business. Principally, they make and service aircraft parts. After the market closed on Tuesday, the company proudly announced a beat of expectations in terms of profits on revenues that matched estimates, increased margins and improved guidance. All of this was on significant growth. So, as you would expect, when the market opened at 9:30, HEI opened about 2% higher than Tuesday’s close. Then this happened.
The stock collapsed. HEI lost over 7% in 15 minutes.
I wasn’t watching it in real time, but when I saw it later there was, it seemed, an obvious explanation. The conference call with analysts and senior management at the company began at 9 AM. I wasn’t on the call, but obviously, Chairman and CEO Laurens Mandelson had dropped a bombshell or cracked under intense questioning from those intrepid analysts and admitted that the seemingly great results were all a fraud. It had to be something like that, so I combed through the transcript.
There was no big confession or prediction of doom. There were two areas of concern, a slowdown in the defense sector and disappointing results at Lucix, the satellite manufacturer acquired by Heico at the end of last year. Defense spending is naturally under pressure as the US faces the first time in over a decade when it was not at war. This is not unexpected, though, and, as a parent of a US soldier, neither is it unwelcome.
Similarly, Heico management has made it clear since the acquisition of Lucix that it was a long term play in an inconsistent industry. There was talk of what Mendelson referred to as “an accounting nightmare” when it comes to cost overruns that Lucix was facing, but again, nothing earth shattering.
So, why the selloff? Just a few weeks ago there was much talk about the pros and cons of HTFs in regard to front running orders, but to me, the biggest potential problem of computerized trading is the potential for the exaggeration of a move that algorithmic trading brings. This looks like a case in point, where somebody, expecting much better numbers than forecast, was disappointed with even the good results reported, or found something to dislike in that call and dumped a position. This selling presumably pushed HEI through a level that triggered more selling, this triggered more selling, etc, etc.
Of course, I, and the multiple Wall Street analysts who re-affirmed “Buy” ratings after the announcement, may have missed something really important here. If so, please inform me in the comments section what that was and I will happily eat humble pie. I have spent too long in trading rooms to have any pride left when it comes to admitting errors. For now, though, I will be operating on the assumption that this is a modern version of an age-old problem. As I have said many times, traders, like radio talk show hosts, are paid over-reactors.
What this does do is to present an opportunity for a trade with a nicely skewed risk/reward equation.
As you can see on the 6 month chart above, this drop has left HEI conveniently close to the previous low at around $50. A stop loss 5% away from the current level around $52 would equate to around $49.40, guarding against a clean break of that support. Most analysts are, post earnings, citing price targets in the $65 (Canaccord) to $70 (Stifel) range, so the upside of the trade is self-evident.
The problems at Lucix and a natural reduction in the outlook for defense spending may well be negatives for Heico, but they are issues that are already evident. The fact is that, even in that environment, by increasing efficiency at acquisitions and old-fashioned organic growth, HEI turned in a stellar quarter. It is possible to tie yourself in knots trying to justify the market’s reaction, or you can just accept it as illogical and stop focusing on this gift horse’s teeth. I prefer to do the latter.