Keep This ELF On The Shelf: Why A Contrarian Trade Doesn't Make Sense

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When a stock moves close to twenty percent after releasing earnings, it always gets my attention. Usually I am looking at fading the move, trading in the opposite direction in the belief that big moves are almost always overdone. Being on the right side of the retracement enables traders to set up a position that has very little or even no downside, while allowing for a good profit should the bounce continue.

That is always an attractive proposition, so when e.l.f. Beauty (ELF) plummeted in the after-market immediately after reporting earnings yesterday afternoon, it piqued my interest.

In many ways, this looks like a classic set-up for the type of trade described above. The post-earnings collapse of ELF not only wiped over twenty-six percent off the stock’s price, it also took it to a fresh all-time low of $11.20. As expected, there was a bounce back, but in this case buying on that bounce makes no sense for several reasons.

The first is that a lack of liquidity immediately after earnings would have made it difficult to establish a long position early in the bounce. Traders would have probably had to buy at this morning’s opening, which looks like being somewhere around $12. Under normal circumstances, that would be okay.

Buying at $12 with a stop-loss just below the low, say at $11, would limit potential losses to less than ten percent, and a return to the pre-drop levels around $15 would represent a twenty-five percent profit. That is a pretty good risk/reward ratio if the upside is realistic but unfortunately, that is not the case here.

First, let’s look at the numbers. The release was messy and confusing, with a net EPS of $0.03, well below consensus estimates of $0.06 and a massive drop from $0.08 in the same quarter last year. That obviously looked bad, but adjusted EPS, after allowing for stock option expenses and amortization, sent the opposite message, coming in at $0.13.

Given that confusion, a better guide to last quarter’s performance was probably revenue which rose six percent, meeting expectations. On balance then, the results were somewhat neutral, and if the big drop were just the result of that so-so performance underwhelming I would be all over the stock at $12.

There was, however, another big reason that ELF fell off a cliff.

The most influential part of an earnings report from a company that gives forward guidance is not what happened historically, but what they think will happen in the future, and ELF made some subtle but extremely important changes to their outlook. They now see 2018 revenue growth as being in “low single digits” as opposed to the previous 6-8%, and EPS in a range of $0.56-$0.61, a wider band than the $0.59-$0.61 coming in to yesterday’s report.

Those may both seem like minor changes and therefore make a twenty-six percent drop in the stock look massively overdone, but, in context, that could not be further from the truth. That context is that so much of ELF’s value has historically been in the perception of the company as one that is growing rapidly.

As the longer-term chart below would suggest, however, reality has not matched that perception for some time.

If that were a result of poor execution of a business plan by an inexperienced management team I guess you could still make a case for buying ELF, but it isn’t. It runs a lot deeper than that.

e.l.f Beauty went public in September of 2016, and the chart above suggests that it was an example of a company whose IPO worked out well for existing owners but prompted over enthusiasm from traders and investors in early trading. The rapid growth that was the foundation of the stock’s value has proven unsustainable.

With hindsight that was somewhat predictable given the inherent trendiness of the beauty supply business. Yesterday’s lowered guidance therefore looks more like a confirmation of a worrying trend than a one-off weak quarter that provides an opportunity to buy the stock at a discount.

Often, analyzing why a trade is not suitable gives more insight than why one is. In this case, at first glance, everything seemed to suggest a short-term contrarian buy of ELF. Everything that is, except the most important things, the long-term trend and medium-term prospects. Both of those suggest that while e.l.f. Beauty is a solid company that can grow, the growth expectations priced into the stock have been, and to some extent remain, unrealistic.

The lesson here is that no matter how good the set-up looks the fundamentals must align for a set-up and idea to become a trade. Taking a minute or two to check the basics after noticing a signal may go against most people’s image of trading as fast-paced, but over time it will save you a lot of money.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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