Better than expected earnings and technical price action follow through is perhaps my favorite combination when trading a stock. My background in public accounting leaves a warm place in my heart for management teams that execute on their business plan and are able to surprise Wall Street to the upside. Smith & Wesson (SWHC) changed the direction of its chart with a huge increase to its revenue and earnings forecast and then a breakaway gap in January. It later reported those strong results in early March. This morning we're seeing a continuation gap to further strengthen the case that SWHC is now in an uptrend as management announced this morning that the company will once again trounce its quarterly estimates on both the top and bottom lines as firearm sales are very strong.
First, let's take a look at the downtrend that SWHC was mired in just prior to its raised forecast in mid-January:
There are a number of points we can discuss here. First, I think it's fairly obvious that SWHC was trending lower throughout the second half of 2014. Some may have argued that the trendline was broken in mid-November as the trendline that connected the prior tops in June, August and October was cleared. Technically, I can't argue that point. But something was missing - VOLUME! I don't buy any breakout that lacks conviction (ie, volume confirmation). Think about it, who's buying? Answer: No one. The other red flag is that despite this "breakout", SWHC continued downtrending against its own peers in the Dow Jones US Defense index ($DJUSDN). Does that sound like a breakout to you? It sure doesn't to me. We did begin to see a little relative strength in January, as evidenced by the black circle. If you look at the chart, you'll see the uptick in volume and SWHC's price move to a two month high, clearing reaction highs in both November and December. The real game changer in my opinion, however, was the massive volume spike to a 4-5 month high. Relative strength returned in a big way as well and the race back to the upside was on.
Now let's fast forward to today, April 15th. SWHC announced this morning that it now expects its EPS to come in between .34-.36 (vs. consensus estimate of .27) and its revenues to be 175-179 million, well above the current estimate of 164 million. So revenues are expanding rapidly as are earnings. That's the recipe for a high octane momentum stock. Take a look at how Wall Street has been anticipating the news:
In a nutshell, SWHC is a perfect example of how and what I like to trade. First, identify a company that is executing its business plan, as evidenced by quarterly results that top Wall Street consensus estimates. Second, place it on a Watch List at StockCharts. Third, run daily scans of this Watch List looking for certain attributes. I generally run a volume scan against this list early in the trading day - usually the first hour or so. Another scan that I run against this Watch List later in the trading day centers around RSIs in the 40-50 range. By placing a stock on this Watch list, I already know that I like the company fundamentally. The 40-50 RSI tells me that we've seen a nice amount of consolidation or selling that likely improves my reward to risk entry level. From there, I can decide if I want to buy, how much and at what price.
Getting back to the chart, note that SWHC printed a long-term negative divergence on the early March high as its earnings were released. RSI was also above 70. Most traders make the mistake of chasing companies when they're overbought like this because it feels good. Psychologically the stock is moving higher so it's easy to buy. You feel validated. The problem with this strategy is where do you set a stop loss? Every company deserves a period of selling or consolidation, especially those showing signs of slowing momentum (negative divergence on MACD). From a reward to risk perspective, you're generally much better off having the patience to buy solid companies at cheaper prices. Doesn't that just make sense? If the stock keeps rising without a hint of consolidation, just congratulate those who bought or chose to hold and look for a better REWARD TO RISK scenario. Buying an already overbought stock is not the risk I want to take.
Late March or early April appeared to be a much better reward to risk entry after SWHC had settled down for a period of weeks and allowed its momentum oscillators to unwind. The MACD fell back to centerline support to "reset" as I like to call it. The RSI touched 40 and the stochastic was in single digits. During an uptrend on a fundamentally strong company, this was the much better opportunity to enter the trade. It NEVER guarantees us success, but it certainly reduces the risk.
Happy trading!
Tom
