Some Industries Are Dangerous to Long Term Investors
In the stock market, each stock has its own personality. Some trade with extreme volatility while others move slowly over time. The same is true for sectors and industries. The term “sector” is often misused when talking about the stock market so let’s begin with some definitions.
A sector is a broad grouping of stocks. In general, most classifications will include about a dozen different sectors and then place each stock into one of those groups. For example, the financial services sector will include banks, life insurers, investment managers, property and casualty insurance companies and other firms.
Each sector can be broken down like that. The grouping within a sector is an industry or a group of companies whose businesses are highly similar to each other. For example, McDonald’s Corporation (NYSE: MCD) and Chipotle Mexican Grill, Inc. (NYSE: CMG) would both be in the restaurant industry.
Industries Carry Different Levels of Risk
Sectors are broad and that means they are generally diversified. While companies in the same sector will share some characteristics, companies in the same industry will share almost all of the same risk characteristics.
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As an example, we can consider the education and training services industry. Companies in this industry serve varying needs but are sometimes all lumped together under the category of “for profit education.”
As an industry, for profit education providers serve a market niche. They generally offer education opportunities to nontraditional students. They often rely on accelerated and convenient schedules to deliver education to students who want to enter the workforce quickly.
But, the industry is the subject of a great deal of controversy at times. These schools can be high priced and many have high attrition rates. To meet the high costs, many students rely on education grants and loans. The high attrition rates mean that some students will not be able to easily pay off their loans.
These factors present unique risks to the companies. The stocks in the industry tend to suffer declines together when one of the companies appears in the news in a negative light. This is a risk that can be called “headline risk” and is unpredictable.
Although headline risk in the education industry is unpredictable as to its timing, it is predictable that the risk will occur fairly frequently. This has led to volatility for stocks in the sector.
Even companies with good fundamentals have declined on news related to the industry.
This can be seen in the chart of Grand Canyon Education, Inc. (Nasdaq: LOPE). The company has grown earnings per share (EPS) at an average rate of 20.7% over the past five years but the stock has suffered large declines when the Department of Education announced investigations into competitors.
High Risks Require a Strategy
Grand Canyon Education traded as much as 10% higher on Wednesday after announcing earnings that were better than expected. The company reported EPS of $0.83, much better than the analysts’ consensus estimate of $0.68.
The company also reported that enrollment increased 10.5%. Grand Canyon was teaching 74,485 students at the end of the second quarter, with 6,015 of those students taking classes at the university’s physical campus located in Phoenix.
Growing enrollment, and a large student body, combined with a physical campus indicates Grand Canyon is likely to be a long term winner in the industry. But, there will continue to be headline risks for companies in the industry as bad actors are investigated and, at times, shut down.
That means it could be best to avoid a long term investment in Grand Canyon, and the entire adult, for profit education industry. However, that doesn’t mean short term strategies should be avoided. These stocks can be volatile and volatility can be useful and profitable for traders.
To develop a short term strategy, we should understand how LOPE normally trades after an earnings report.
Grand Canyon soared on news that the company had exceeded analysts’ estimates. History shows its behavior was in line with past quarters. Typically, the company exceeds analysts’ expectations by about 10%. This was the 26th consecutive quarter that the company reported earnings that were better than expected.
Despite its history of beating expectations, traders seem to consistently be surprised by the news. The stock has delivered an average gain of 10% in the week after earnings are announced. This quarter, the stock achieved its average gain in the morning after announcing its quarterly results.
A Specific Trading Strategy
After a large gain on one day, we should expect a stock to consolidate its gains over the next few days to weeks. There could even be an upward drift within the trading range to account for buying from momentum traders.
The expectations for a trading range to develop is especially true when the stock is trading near, or even slightly above, its fair value.
Analysts expect Grand Canyon to report EPS of $3.66 for the full year. They are looking at EPS of $3.95 in 2018. At the current price, the stock is trading at about 20 times next year’s estimated earnings. Given its history, Grand Canyon is likely to exceed these estimates but the price to earnings (P/E) ratio remains elevated, even with an earnings beat of 10% factored into the calculation.
With Grand Canyon trading near fair value, additional large gains, especially in the short term are unlikely. However, a small gain is still possible. To benefit from this expectation, a bull call spread can be used.
A bull call spread is a strategy that involves two calls. Each will have the same expiration date. The trader will buy one call and sell a second call with an exercise price that is higher than the exercise price of the option they bought.
Selling the option, in effect, reduces the cost of the option that is bought. But, the option sold will always be priced less than the option that is bought. This means a debit will be created to open the position although the initial outlay will usually be only a few hundred dollars.
The risks and potential rewards of this strategy are shown below in a diagram taken from The Options Industry Council web site. Both the risks and gains of the trade are limited.
On Wednesday, LOPE closed at $80.01. To open the bull call spread, a trader could buy a call option expiring on August 18 with an exercise price of $80. This option is trading for about $2. Each contract covers 100 shares so the total cost would be $200.
To help reduce the cost of the trade, a call option expiring on August 18 with an exercise price of $85 could be sold for about $0.40, or $40. This makes the cost to enter the trade about $160, ignoring the cost of commissions which should be small at a deep discount broker.
The maximum risk on this trade is equal to the amount paid to open the trade, or $160 in this case.
The maximum possible gain is equal to the difference in the exercise prices of the options less the amount paid to open the trade. In this trade, the difference between the exercise prices is $5, making the total risk is $500 since each contract covers 100 shares. The maximum gain is then $340 when the premium paid is subtracted.
This trade offers a potential gain of more than 212% on the amount of capital risked, a significant gain on a small amount of capital.