Sell in May, But Don't Go Away

Declan is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The most recent high for the S&P qualified the market under a 'sell' criteria for my Investing Strategy. The last time this happened was in March-April 2012, when the index went on to shed nearly 11% from peak-to-trough by the time the market bottomed in June 2012. However, this should not be viewed as a clarion call to sell everything, but may instead offer a better opportunity to generate income using a covered call strategy; or at least sell underperforming stocks that are likely to get hit hardest by any subsequent broad market sell-off.

March Income Review

I had highlighted three stocks that had potential as covered call candidates. Tesoro Corporation (NYSE: TSO) was one of the early features from March 2012. Its May $55 call was offered at $4.70, and is now around $3.20 with expiration this week. This could be rolled into an August $60 expiration with a bid around $4.05. May earnings are already out of the bag: Q1 earnings in the absence of special items was $0.67 a share off $93 million; this compared very favorably with the $56 million and $0.39 per share earnings from the same quarter last year. The company also ended the quarter with $2 billion in chump change. Going forward, it was "optimistic" on U.S refining market conditions, with a sub-10 forward P/E suggesting further price upside with competitors trading at P/E's around 10.8.

Krispy Kreme Doughtnuts (NYSE: KKD) offered a May $13 call at $1.20, and this contract may close flat after the stock peaked in the $15's during mid-March. An analyst downgrade sent the rats scurrying, but the stock is up over 60% since it was featured back in October. The company trades at a P/E similar to Dunkin' Brands Group, but with a forward P/E around 10% more competitive than its rival at 19.1. However, the selling volume associated with the downgrade suggests few are willing to support the current P/E in the forties, so it might be time to lighten the load.

Tenet Healthcare (NYSE: THC) took more of a battering in April after a lengthy advance. Better than expected earnings from what was "one of the industry's weakest volume quarters in memory" gave bulls something to work with, but April saw sharp spikes in selling volume which will keep sidelined buyers skeptical. "Pocketbook" factors: a mix of higher co-pays, lower paychecks, and a soft economy will continue to pressure earnings, and the recovery noted in April may not be sustainable without improvement in these segments. In addition, the company noted how patients were opting for plans with higher deductibles, with a 25% rise in patients carrying deductibles in excess of $1,200. Higher deductibles means fewer admissions. With premiums rising, the likelihood is for this to get worse as health care providers offer 'cheaper' plans with even higher deductibles. I had originally featured Tenet Healthcare in November 2012 when it traded around $25, but now that it's trading in the upper-$40s it looks a good time to let this one go.

Underperformers

Despite the strong rally in the S&P, a number of featured stocks simply haven't managed to keep pace. These stocks are likely to suffer more than others when the broader market rally fades. The Materials and Commodity plays have suffered the most: Potash Saskatwchewan, Freeport-McMoRan Copper, Randgold Resources and Pan American Silver are down between 5% and 35% from their featured prices. Materials have managed to recover a little in recent weeks, but it's a long way back for the Precious Metals miners: lower commodity prices and increased mining costs will keep the pressure on and drive share prices lower.

I have already covered the disappointment of Penn Virginia after its massive share dilution. Auxilium Pharmaceuticals (NASDAQ: AUXL) is down over 30% from its original feature in June 2012. The stock was hit by weak Q1 earnings, which itself knocked 13% off the share price. Its primary revenue generator, Testim, saw a 22% drop in sales, generating $45.5 million. While Xiaflex saw a more modest drop in sales of 4% to generate $12 million (although $7.4 million of this was from Pfizer), not surprisingly the company lowered guidance for the year. A slowdown in global Testerone Replacement Therapy contributed to the weaker Testim sales, and this is likely to remain the case for the foreseeable future. Auxilium Pharmaceuticals looks to be placing its growth prospects on its recent Actient acquisition and the $125 million in sales it brings to the table.

Other also-rans include Garmin, down over 20%, although its 5% yield will have alleviated this loss to a certain extent. And The Fresh Market, with a loss approaching 25% from its feature price. Two very weak quarters hammered the stock as same store sales growth limped at 1.9%, compared to 5.7% over 2012. This reduced guidance from $1.68 per share down to the $1.51-1.58 range. Further misses will lengthen the projected P/E of 22.6, with competitors trading at an average P/E of 26.7 (although Whole Foods Market runs at a more heated P/E of 35.0).

Outperformers

Luckily, a number of stocks have gone on to exceed expectations. I have already covered the big gainers of Tesoro Corporation, Krispy Kreme Doughnuts and Tenet Healthcare. Honorable mention to Obagi Medical Products, which was bought out for a 70% gain on its feature price. The other big winner on the list is Medidata Solutions (NASDAQ: MDSO).

Medidata Solutions got a healthy boost at the end of last month after reporting record Q1 results. Comparable quarterly revenues were up 26%, with backlog growth of 46% over the comparable year last. 31% year-over-year growth came from application services, which accounted for $50 million in revenue. Customer retention and upselling were key factors in earnings growth. This had exceeded the company's own expectations: "On the heels of Q4's record sales performance, our team had the best first quarter in history;" all good signs for the quarters ahead. As a finishing touch, cash holdings also increased by $12 million to $124 million in total. The stock is up over 90% from its original in August 2012.

A cluster of stocks have had a good run over the past few months, but the pick of the bunch is Pinnacle Entertainment. It gained 33% in the past couple of months, to give it an overall 55% return on its feature price. The Ameristar merger is expected to close by Q3 of this year, which will offer $40 million in savings. Revenues increased 6.7% year-over-year, although performance of individual properties was mixed, with weakness usually attributed to remodeling-related disturbances. A new $20 million development is planned for New Orleans, to open in Q2 2014.

Any stock up over 25% in the past couple of months is worth looking at as a covered call opportunity. Nine (out of 104) stocks featured in my articles have achieved this goal. The aforementioned Medidata Solutions has June $70 calls offered at $1.70, while Pinnacle Entertainment has September $20 calls offered at $1.65.

Summary

For many people, this is great opportunity to restock the cash coffers in preparation for the next move higher. This can be achieved by cutting losers, taking partial profits on gains, or selling covered calls. The next leg down may offer 10% discounts or more, even allowing fresh opportunities to buy back the same stocks for less! Although each major rally is typically led by a different group of stocks. You want to make sure you have the funds to buy the next winners. 

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Declan Fallon has a position in Freeport McMoRan Copper.. The Motley Fool recommends The Fresh Market. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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