An Irresistible Pre-Earnings Trade

In some ways, buying a falling stock in front of earnings isn’t a smart thing to do. There is always the chance that there are people out there who know more than you do and that the drop is the result of that knowledge. Furthermore, it could be argued that when sentiment around a stock is extremely negative, even what looks like a generally good earnings report will be picked apart for weaknesses to justify more selling. However, for those of us with a more contrarian trading style, a big decline in the price of a stock in the runup to earnings sometimes looks like an opportunity. It sets up a sell the rumor, buy the fact scenario, where profit taking will limit the downside even if the results miss expectations, and it also means that the whisper number is probably way below the published analysts’ estimates, so even an average quarter will look good.

That is why, even though the beginning of June looks like this, I intend to buy Canadian Solar (CSIQ) in front of their calendar Q2 earnings release, which is scheduled for Tuesday, August 22^nd.

CSIQ’s drop hasn’t just been about upcoming earnings. It has also been a result of weakness in China, a key market for them. That part of it I understand in some ways, but it looks to have gone too far, especially considering that economic weakness in China is not the same in its scope and implications as weakness in the West. The Chinese government can target stimulus quite easily, and is forcing the transition to solar power, so there is a good chance that the industry will escape the worst of any downturn that may materialize.

If you discount or at least play down those fears, what you are left with is a curious anomaly. CSIQ is falling out of bed in front of earnings, despite being one of the few companies this quarter who are expected to report positive growth. The consensus view is for EPS of $1.52, 42% above the same quarter last year, on revenue of $2.5 billion, representing just over 8% growth. That drop might make sense if the stock had been hugely overvalued a few months ago, but that really isn’t the case and CSIQ is now trading more than 30% below where it was a year ago.

Does that make sense to you? A 30% drop on a 42% increase in profits? No, it doesn’t to me either. And on top of that, every value metric suggests that the stock is undervalued at these levels. Forward and trailing P/Es stand at 6.3 and 6.9, respectively, with a PEG ratio, where a value below 1.0 indicates value, of 0.25, and CSIQ is trading below book value and at only 0.29 times sales.

The strong impression of value that all that creates is also backed up by the technical picture. The stock is just around 10% above what has proven to be a solid support level in the past at around $27.

If nothing else, that makes for a good level off on which to base a stop loss, and, should earnings beat expectations, the rush to exit all the short positions could create a significant upside.

Obviously, this is not a trade for the faint of heart. As I said earlier, buying a falling stock in front of earnings always poses a significant risk. But a stock expected to show good growth at a time when growth is scarce, and which is trading way below any logical calculation of its actual value, is just too hard for me to resist. So, I will be picking up CSIQ at around $30, placing a stop at $26.80, and crossing my fingers. Wish me luck!