In the Penalty Box

What Is “In the Penalty Box”?

"In the penalty box" is a phrase referring to a company impacted by an event that keeps its stock price down for a substantial amount of time. Frequently, a firm that does something illegal or unethical will land in the penalty box because of the loss of trust. However, companies can also end up in the penalty box for missing earnings expectations, failed product launches, or anything else that undermines confidence.

Understanding “In the Penalty Box”

A company in the penalty box is often one that has received some bad news, ensuring poor returns for its stock in the future. An example of this is a drug company with a key drug that doesn't get the Food and Drug Administration (FDA) approval. These types of companies will often stay in the penalty box for a long time. They might be unable to gain traction in the market or gain investor trust to raise capital. The term is widely used among professionals in the financial world to describe stocks that are not predicted to gain value.

The term "in the penalty box" comes from the sport of hockey. When players break the rules in a hockey game, they go in the penalty box near the player's bench. For a designated period, typically two minutes, a player is out of action, and that team must play short-handed. As a result, most teams go on the defensive. They aim only to prevent the opposition from scoring instead of trying to score themselves.

Stocks that are in the penalty box may act the same way. Stocks in the penalty box might not be able to gain much. However, they may be able to stay afloat in the market and avoid significant losses. Stocks in the penalty box do not necessarily keep falling after the initial negative impact of the event that put the company in the penalty box. Instead, the stocks of companies in the penalty box are more likely to be trapped in a trading range.

Benefits of “In the Penalty Box”

Being in the penalty box obviously has no benefits for the companies involved, but it can provide benefits for investors. Value investors often find bargains in the penalty box, particularly when the company has a long history of success. For example, Warren Buffett made a large investment in Bank of America when the company was in the penalty box after the 2008 financial crisis. The key here is to invest when a fundamentally sound business suffers a public relations setback that puts it in the penalty box. The idea is that the firm's management will fix the mistakes, and investors will forgive the company.

Stocks in the penalty box can also be profitable for certain types of speculators. Suppose a stock in the penalty box enters a trading range. In that case, it can be easier to identify support and resistance levels. The speculator can repeatedly buy the stock when it hits support, then sell or short sell the stock when it hits resistance. The best part is that the speculator knows to stop when the reason for the stock being in the penalty box is eliminated. For example, the replacement of an unsuccessful or corrupt CEO might be a signal to stop shorting the stock when it hits resistance.

Criticism of “In the Penalty Box”

The stock market is not a hockey game, and the claim that a particular stock is "in the penalty box" is usually very arbitrary. The "penalty box" is not nearly as well defined as a Darvas box or other proper technical indicators. That makes it difficult to evaluate, test, or refine the concept of "in the penalty box." A commentator will typically claim that a stock is in the penalty box after bad news and a fall in the share price. However, the same commentator usually makes no usable predictions about how long this condition might last or what will bring it out of the penalty box.

When a stock previously considered to be in the penalty box rises to new highs, it will typically receive favorable coverage again. There will usually be no mention of the penalty box or how the company got out of it. That is different from bull and bear markets, which have clearly defined beginnings and endings. According to some critics, "in the penalty box" is simply a false analogy or meaningless catchphrase with no practical applications for investors.