Earnings season is an emotional time on Wall Street, and I think it's the perfect time to revisit Ben Graham's famous description of "Mr. Market."
Ben Graham was Warren Buffett's business school professor. Graham wrote several books explaining how he thought about the markets, and in one of those books, he compared the market's price swings to the lunatic ravings of Mr. Market. In Graham's description, when Mr. Market is happy, he will bid the price of stocks up. But suddenly and often for no apparent reason, Mr. Market will fall into a deep fit of despair. Then he wants to sell all of his holdings at low prices, and he won't take no for an answer.
Graham explained that it's important to ignore Mr. Market and make buy and sell decisions based on value. This can be difficult to do because it's easy to get caught up in the market's reaction. But both Graham and Buffett achieved success by ignoring the market swings and focusing on value.
Sometimes, Mr. Market's judgment is entirely rational. Selling may seem to come from nowhere and be extreme, but it may actually be the right response. This is especially true during earnings season.
Market prices are forward-looking. Analysts use all of the information available to decide what the value of a stock should be. In earnings season, new information becomes available, and analysts have to re-evaluate their models based on these new facts and insights. That's why we see stock prices make large and rapid moves in earnings season.
But occasionally, Mr. Market's emotions push prices too far as traders overreact to news. In these cases, Mr. Market is actually giving us an opportunity.
Overreaction: When Mr. Market Goes Too Far
As an analyst, it's my job to find the times when Mr. Market goes too far. I do believe in most cases the price changes we see after an earnings report are in line with the new information. Opportunities to benefit from a steep selloff, for example, are rare.
But this week the market provided us with one of those opportunities in United Rentals (NYSE: URI).
I've written about this company in the past within my premium newsletter, Income Trader. United Rentals rents equipment to construction companies and others who need industrial equipment. The company provides customers with access to about 3,300 different types of equipment like backhoes, forklifts, and boom lifts through more than 880 locations. In addition to serving the commercial market, the company also provides equipment to homeowners like pressure washers and smaller earth-moving equipment. Altogether, the company has 400,000 different pieces of equipment available for rent.
For many businesses, renting this kind of expensive, occasional-use equipment makes the most sense financially and operationally. A small home repair contractor might need periodic access to digging equipment or lifts to access different areas of a home. Similarly, independent small business owners might not have the capital to buy several pieces of equipment, not to mention the space or money to store and maintain it. With a nearby United Rentals location, they don't have to. They can rent what they need when they need it.
While the value of this service to small contractors is obvious, small towns and other government agencies are also frequent customers of United Rentals. Large companies can save money by renting equipment they need infrequently or by essentially outsourcing maintenance and accounting to URI.
This is an attractive business opportunity for United Rentals and its customers. Competitors could be tempted to try their hand at the business, but there is a high barrier to entry that protects URI from excessive competition. URI has a fleet of equipment that is worth about $9 billion, with more than 880 locations and 12,000 professionals to help customers get exactly what they need. It would take decades for a competitor to develop a network like that.
The Downside Of Industry Leadership
Size makes URI an industry leader. But it also means the company's performance is tied to its industry performance. Lately, that hasn't been a great relationship.
Recently, United Rentals reported earnings that seemed to disappoint investors. Analysts cited weaker-than-expected rental rates as a cause of the shortfall. Concerns over continued weak pricing pushed the stock down. The selloff can be seen in the chart below.
The question we face is whether the selling has gone too far. To find the answer to that question, I dug into the earnings report.
The company reported earnings per share (EPS) of $1.63, better than analysts' expectations of $1.58. Revenue of $1.36 billion was below expectations of $1.34 billion. Management also upped its full-year revenue estimates to a range of $6.05 billion to $6.25 billion, in line with analysts' expectations.
Two Paths To Profit From This Selloff
In response to the announcement, analysts have revised their estimates upward for this year and next. They now expect URI to report EPS of $9.52 this year, up from $9.44 a week ago. They increased estimates for next year's earnings to $10.54 a share from $10.43. The Schanges are small, but bullish.
In light of that, it's likely the selloff was an overreaction. Now, the traditional value investor would see this situation as a chance to buy a high-performing stock at a discount. The investor could then simply ride the stock's price increases back up to, and hopefully beyond, previous highs.
But while this could work, and likely will in this case, the investor must also account for two realities of this type of simple investing. The first is that even if prices do rise as expected, it likely won't be before the company makes a major announcement (like the next earnings release) or a piece of industry news arrives to drive interest in the sector, and either could be months down the road.
More important is the second bit: As all veteran investors know, nothing is guaranteed in the stock market. Any unexpected data point or fickle investor sentiment could again tip the scales against United Rentals, leaving the investor with further-devalued shares.
How You Can Win Almost Every Time
What many investors don't know is that this recent price move also sets up a high-probability, high-income opportunity in United Rentals in short-term options that expire before the next earnings announcement. Rather than buying the stock and hoping for the best, this surprisingly simple options trade allows us to take a greater in a shorter time.
The strategy I'm using for this trade, selling put options, is the same one my Income Trader readers and I have been using to make thousands of dollars in extra income each month. In this case, a rise in the price of URI would earn you a 50% annualized return.
And what happens in case of a drop in price could be even better. If URI is trading under the expected price when your options expire in 15 days, you get to essentially buy the stock at an even greater discount (a full 7.2% less), leaving you with a solid stock at a price you could never get by waiting for price drops.
If you want more information on how my subscribers and I are earning reliable income on our trades with a success rate of over 93%, I invite you to go here.
This article originally appeared on Street Authority.