As a trader, you should always be searching for ideas where the security you’re looking to trade is either outperforming or has the potential to outperform the broader market.
When the broader market is showing weakness as it was earlier this week, that means bullish traders must look for stocks that have been showing strength in the face of adversity.
One method that can assist a trader in this process is to look for companies that have an “economic moat.”
Today, we’ll discuss the meaning of this term, uncover how a company achieves this status, and identify one company with an economic moat that has been developing a strong long-term price trend of late.
Obviously, when we think of a moat we think of a large trench that would have been dug around a medieval castle and filled with water to protect against attack.
The wider and deeper the moat, the more protected the castle.
Ever since Warren Buffet described ‘economic moat’ as his main investment strategy during an interview with Fortune magazine in 1999, there has been a lot of interest in this term.
During this interview, Buffet proclaimed, “The key of investing is not addressing how much an industry is going to affect the society or how much it will grow. But, rather determining the competitive advantage of a company. The products or services that have wide and sustainable moats around them are the ones that deliver rewards to the investors.”
Quite simply, if a company has an economic moat it holds a competitive edge over others.
Companies with economic moats have rapid growth potential and high profit potential.
Typically, having an economic moat allows the company to keep growing and gaining market share, ultimately leading to increased profitability.
How does a company achieve a strong economic moat?
It takes years for a company to build an economic moat.
It’s a process that depends largely on building a strong enough brand that demands pricing power.
In other words, no matter if the company decides to increase the price of its goods or services, the company’s products are so highly desired that there will be no drop in demand.
This is because the company has invested in the following, thereby building the customers preference for their product and brand.
Distribution and sales
Finally, patents and licenses protect the production process of the company’s products.
How can you identify a company with an economic moat?
Now that we have an understanding of the meaning of economic moat, here’s how to identify companies with economic moat.
First, the stock shows solid performance in a slow economy.
Second, companies with strong economic moats will always control market share over their competitors.
I like ServiceNow, Inc. (NOW) for its strong moat and technicals
ServiceNow, Inc. (NOW) provides cloud-based services that automate enterprise IT operations. The Company’s service includes a suite of applications built on its platform that automates workflow and integrates related business processes. It focuses on transforming enterprise IT by automating and standardizing business processes and consolidating IT across the global enterprise. ServiceNow, Inc. is based in San Diego, CA.
ServiceNow not only earns a wide economic moat rating but boasts a positive moat trend, too.
The company has done an exceptional job of expanding beyond its software-as-a-service solution for IT service management into the larger IT operations management market.
Technically, as Figure 1 shows, the stock has been rising in a well-defined upward price channel since the 2nd half of 2020, and is up 22% month-to-date.
As we zoom in, Figure 2 shows that, from current levels, there is still an upside potential of 8% until the top of this channel becomes resistance again.
Essentially, there are two ways for a trader to approach entry into this stock.
First, for traders that want to be more aggressive, believing that NOW will continue to rally from here without interruption, a stop can be placed at the most recent pivot low of $640.12 (see red line in Figure 2).
Why the $640.12 pivot?
Because, by definition an uptrend is a series of higher lows.
Therefore, if NOW were to fall back below this level, the most aggressive path higher (i.e., the most recent uptrend) would suffer an important technical breakdown.
IF such a breakdown were to occur, it would increase the odds of a better buying opportunity developing as the stock tests the $600 breakout area (see black line in Figure 2) and rising 50-day moving average (see blue line in Figure 2), which, as Figure 2 also shows, has a proven track record of acting as strong support.
Though it may feel wrong to market participants that are new to trading markets for corporate executives with knowledge of the inner workings of a company to be able to buy and sell shares in their own company when done by the book this practice is completely legal and represents one of the pillars of capitalism.
As traders, it is our job to always be on the lookout for market phenomena that don’t extend beyond the norm, as such events often present opportunities for profit.
According to Investopedia, “Insiders at public companies essentially have two options for buying and selling their companies’ stock. The first is to conduct the transactions in the open market whereby they buy or sell securities through a broker just like any other retail investor.
The second option is to conduct the transaction on a systematic basis through what is called a 10b5-1 plan. This Securities and Exchange Commission (SEC) rule permits a systematic form of insider trading that is legal. However, the trading activity allowed via 10b5-1 can be beneficial for both insiders and individual investors.” Click here to learn more.
Today, we’re going to look at one company where insider selling has been extreme of late, at a time when the deterioration in bullish trend mechanics may be presenting an opportunity for a bearish trade.
Insider selling by the father of Cavana’s CEO is suspect
Like shares in many companies since the trough of the COVID-19 crisis in early 2020, shares of Carvana (CVNA) have undergone incredible appreciation.
Specifically, from its March 2020 low to its August 2021 high, the stock gained as much as 1160%.
Since the 3rd quarter of 2020, however, there has been a sharp increase in the trend of insider selling, with no insider buying to speak of.
Let me be clear, all sales have been executed through legal channels. It’s just that the sharp rise in the amount of selling is a red flag.
Aside from Jeff Bezos, Mark Zuckerberg, and members of Walmart Inc.’s Walton family, no individual has earned more from selling stock in their company over the past year than Ernest Garcia II, a 64-year-old billionaire, and father of CVNA CEO & Founder Ernest Garcia III.
Ernest Garcia II has sold $3.6 billion worth of stock since October, amounting to 16% of his holdings in the company.
This can be seen on Figure 1 below.
Carvana has already admitted that could be a red flag for some investors.
A securities filing reveals that Carvana’s own filings warn against the “Garcia parties” not being “aligned” with investor interests.
Academics and regulatory types have echoed those concerns, claiming that revisions to the company’s “stock selling plan” (10b5-1 plan) have been changed frequently.
The same parties are concerned that the family owns 85% of the company’s voting shares, in total.
While there is nothing illegal about the structure, the massive increase in insider selling activity is suspect enough for a savvy trader to take a deeper look at the price action to find out the real story.
I always look to price to confirm my evidence
Never forget, price is the ultimate arbiter when it comes to whatever evidence you think you are seeing in your analysis.
The current price is a reflection of what thousands of shareholders, some of them very sophisticated, know about the company.
So when we look at a chart, everything we need to know about the perceived valuation of the company is right in front of us.
When we look at the chart of CVNA, we see a stock that is, at first glance, in the midst of a long-term uptrend.
If we take out some trusted tools from our technical toolbox and apply them to the chart, however, we see what might be the makings of a weakening uptrend.
Specifically, when an uptrend is in the process of rolling over, one of the first places the evidence shows up is in the slope of some of the intermediate-term moving averages, such as the widely followed 50-day moving average.
And when the slope of that moving average starts to turn down and act as resistance, at a time when the RSI momentum indicator has failed to push above 60 during a recent rally, it is often a signal that the longer-term trend is transitioning from up to, at a minimum, sideways.
These developments are made apparent on Figure 1.
Remember, we can’t predict the future of price action, we can only speculate on it.
Therefore, if we control our emotions when we see exciting evidence such as this deterioration, the safest way to play it is with expectations that shares of CVNA are more likely to remain weak or range-bound for a while, rather than betting on an aggressive decline.
If the chart had been showing some sort of a bearish pattern such as a “bear flag,” then that would be a different story.
But for right now, without the presence of an obvious bearish pattern, we have to create a trading plan that takes that into account.
That’s where certain options strategies give us an upper hand, to be able to profit from the simple passage of time in situations when the technicals are not providing any clear indications that price is poised aggressively in one direction to fight the effects of time in a range-bound market.
I like to consider selling a bear call spread on CVNA
At RagingBull, we’re all about finding the chart setups with favorable profit potential and minimum risk.
When it comes to risk management, perhaps no options strategy is better suited than the vertical credit spread.
Let’s walk through the particulars of how we would want to go about placing a vertical credit spread known as a “bear call spread” for CVNA in the coming days.
When it comes to learning multi-leg options strategies, vertical credit spreads are among the easiest and are therefore a great place to start.
Why are they relatively easy to comprehend?
Because they include either selling one put and buying one put (bull put spread) or selling one call and buying one call (bear call spread), and only include options of the same expiration month.
The maximum gain that can be earned from a credit spread is the net credit, realized when both options expire out of the money.
The maximum loss potential is the difference in strike prices – net credit. Realized when both options expire in the money.
In the case of CVNA, the trade setup would be as follows:
Identify the trade bias (we’ve identified a bearish setup)
Identify where the stop-out level is (let’s call this the anchor point).
Identify the strike levels that will allow you to enter the trade with what would ideally be no worse than a risking 4 to make 1 setup. There is some leeway here, but generally, you should try not to risk more than 4 to make 1.
Let’s break each bullet down a bit further.
For bullet 1, the highest probability trades usually occur when a trader is trading with the trend, not against it.
In this case, we’re using the lower slope of the 50-day exponential moving average as our indication that the intermediate-term trend is now lower.
For bullet 2, we’ve identified that the 09/16 pivot high is the level that must hold as resistance if the newly bearish intermediate-term trend characteristics are going to remain in effect.
Therefore, the 09/16 pivot high of $345.98 is the ideal stop level (i.e., the anchor point).
When it comes to bullet 3, this is where we must start exercising patience.
I’m constantly preaching how important it is not to chase trades and to let the trade come to you.
When it comes to this CVNA trade idea, the trader’s ideal spread entry would be for him or her to be able to sell a call option that anchors as close to the $345.98 pivot high as possible and buy a call option with a strike that is roughly $10 to $20 above that area.
The market has sure given us all some chills this week, no matter how big or experienced a trader you are…
I mean just have a look at the SPY chart of the past few days:
There were a number of factors that concerned traders and investors alike, but the biggest one was perhaps the “Evergrande situation” – something you likely heard of if you pulled up any piece of news this week.
And in case you’re wondering how one Chinese property developer can send the entire US stock market running scared for its life – I’ve got you covered.
Let’s discuss what exactly has happened, is happening, and what may happen next.
See, we’re not talking about an average property developer here.
In fact, Evergrande Group is anything but average.
The company is the second largest property developer in the world’s second biggest economy and, quite possibly, the single greatest beneficiary of China’s building boom of recent decades.
At the height of its might, the company would put millions of new apartments on the market every year – it even became the world’s most valuable real estate company in 2018, with a market cap of around $50B.
But all good things must come to an end, and as of this week, the end of Evergrande may be just around the corner.
Some $305 billion (!!!) – yes, with a B – in debt that the company is currently unable to make payments on.
Evergrande’s (and Chinese) Debt Issue
Let’s set aside the obvious fact this is an astronomical amount of money owed by a single company, and look at what’s happening in the bigger picture.
China has grown fast, there’s no denying that.
But so has its debt. Here’s a good chart I grabbed from CNBC to give you a good idea of just much the country’s Debt-to-GDP levels have ballooned over the past decade:
The incredible successes of many Chinese businesses often came at the cost of dangerous overlevergaing and outsized borrowing.
And I know what you may say – don’t we, the US, have high debt levels as well?
For sure, but with one caveat – for all means and purposes, China is still a developing nation!
Many economists express worry about rising debt in well-developed nations, but for one that’s still economically developing – Chinese numbers are simply unprecedented.
Concerns over the out of control borrowing in the PRC have been voiced for a long time, but companies and the government itself have managed to navigate both liquidity and reputational risks… Until now!
The world is watching, fearing that Evergrande may very well be the first piece of the domino, about to set off a dire chain of events.
Many in the media even go as far as to call it “China’s Lehman moment” – referring to the infamous collapse of Lehman Brothers that triggered the 2007-2009 financial crisis.
What’s Next For Evergrande?
The Chinese authorities are facing a dilemma right now:
Bail Evergrande out, save Chinese consumers and reputation, but set a bad precedent to other overleveraged businesses.
Let the company collapse, do significant damage to investor’s reputation, risk major shockwaves in other parts of the economy, but stand firm on its policy of addressing the debt issue going forward.
It’s coming in a surprise to many, but current indications point that the government is willing to go with the latter option – let the company burn.
Here are some of this mornings headlines:
So here comes the question you’ve all been meaning to ask this whole time…
What Does This Mean for Us, Traders?
Now, I get it… For a guy who mostly trades based on price levels, chart patterns and news catalysts, I’m talking way too big of a deal about a global macro event.
But don’t underestimate its meaning.
First, as a trader, you should always be aware of the bigger picture – if an event can crash SPY 15 point in 2 days, you better know what it is about.
Second, global reverberations of this magnitude are almost sure to affect risk appetites around the world.
For one, Chinese stocks may very well see shrinking valuations – adjusting for added risks.
For example, here’s Alibaba – BABA, breaking below it’s long-term support:
Second, if the Chinese economy is in fact significantly crippled over Evergrande’s collapse – the US economy will get hurt too, and so will our stock market.
Personally, I think this is good enough reason to lighten up on high-flyer names for now – if stuff hits the fan, those may be the first ones to fall.
Now that emotions seem to be more or less priced in, I really want to see how the US market reacts.
So far, this week’s action in SPY looks like yet another perfectly rebought dip:
But I’m not convinced yet – for confirmation that the worst is behind I want to see no trouble climbing over the $445 level and then above $448.
If at any point SPY starts failing, it may very well be the time to get more aggressive with my short positions.