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In
This Edition... |
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We've got some
heavy-duty food for thought today regarding ALCOA's miss from earlier this
week, and the (largely errant) effect it had on some other stocks. Let's
just say not enough investors asked the right questions in the post-announcement
frenzy.
Before that,
however,
we want to draw your attention to one of this week's blog entries.... 'Projected
Valuations, Earnings Growth By Market Cap'. It's a pretty eye-opening
comparison of how well different market cap groups are expected to perform
this year in terms of earnings increases. Some of the forecasts aren't
even plausible, while others may leave little room for price appreciation....
depending on how tolerant/forgiving investors are in 2010. Be sure to check
it out.
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Right
Idea - Wrong Stocks: Sorting Through ALCOA's Earnings Victims |
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Earlier
this week, what started out as an apparently-savvy strategy for some investors
quickly turned into a debacle when ALCOA (AA) failed to meet earnings estimates
for its prior quarter. The debacle wasn't just the aluminum company itself
though - it was also the instruments most investors chose to make the play
on what had been hoped to be solid numbers from ALCOA.
 Those
instruments? Caterpillar (CAT) and John Deere (DE). Both stocks ran
up in front of the news, and then got punished when the news ended up being
bad.
While most participants
in the trade - as well as third-party observers - may look back
on the fiasco and shake their head or roll their eyes in regret, it actually
wasn't a completely flawed premise. It was simply mishandled in
too many ways.
So, here's a
look at what was right, what was wrong, and what we can learn from the
ALCOA/Caterpillar/Deere saga. We'll wrap up with a bigger picture outlook
on the industries.... something many investors forget about in the heat
of the moment.
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Doomed
>From the Beginning |
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The thought
process was simple and rational. If ALCOA and the rest of the aluminum
industry starts humming again and restores profitability, then the underlying
strength that caused it should be the same underlying strength that drives
revenues and earnings for companies like Caterpillar and John Deere as
well. After all, what's good for one industry is good for all of them,
right?
 And,
with ALCOA scheduled to release last quarter's encouraging results after
the close on the 11th, waiting until the 12th to step into such a stock
would be too late. Thus, CAT surged 6.3% on the 11th, hitting new highs.
DE did the same with its 4.0% rally.
Unfortunately,
ALCOA's numbers were disappointing. Analysts were looking for an adjusted
EPS of $.06. The company only posted a profit of $0.01 per share though
.....short by more than a little. That weakness spread fast, driving AA
shares lower on Tuesday, and spreading to most other stocks as well that
day (surely ALCOA's woes must mean the economy is close to unraveling).
CAT and DE weren't immune to the bearish infection either. All those well-laid
plans blew up in investors' faces, even if only for a day.
The entire saga
raises (or at least should raise) several questions. A few of the most
important ones investors should be asking are:
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 Why
exactly did ALCOA fall short?
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Should we be using
ALCOA as a market proxy?
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What does the aluminum
market actually look like right now?
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Even if ALCOA aced
earnings, were Caterpillar and John Deere the top ways to play it?
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If not, then which
industrial machinery stocks are better positioned?
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What can we actually
expect from either industry going forward?
None of those questions
were asked on Tuesday though. Getting out of those stocks was the only
concern in the ALCOA aftermath.
In retrospect,
and with respect to the huge runups from all those names, one has to wonder
if we were going to see a case of "Buy the rumor. Sell the news."
no matter what ALCOA reported. That's hardly the end of the story though...
or at least it shouldn't be.
Since the answers
to those six questions are at the heart of the matter (in fact, they ARE
the matter), we can best make our points and voice our projections by answering
each one individually.
Q. Why exactly
did ALCOA fall short?
A. Revenue was
a little lower than last year, but a little higher than expected; a 9%
increase in the price of alumina helped. Profits were still crimped though,
thanks to higher energy prices and a weak dollar (which hurt its overseas
operations). However, neither are really under the company's control.
Q. Should
we be using ALCOA as a market proxy?
A. Not really.
The entire aluminum industry is still dealing with excess inventory and
ALCOA itself is still putting up huge one-time charges. This makes it difficult
to get a bead on the company's actual health; ALCOA just may take longer
than the average company to fully rebound. So, though alumina usage is
improving and the economy is growing, it may not be evident in terms of
profitability for this stock, or even the industry. Factor in the effect
of a weak U.S. dollar, and ALCOA is a particularly poor proxy for the market.
[Be sure to review the next question/answer, as it's closely related.]
Q. What does
the aluminum market actually look like right now?
A. Aluminum
prices fell 60% at the end of 2008 and early 2009 ... in line with demand.
After stabilizing for the better part of last year, prices started to improve
again (by 9%) in Q4 of last year. So, demand is improving if price is any
indication.
The problem
is the lingering overhang of excess inventory that could crimp aluminum
prices, and therefore corporate margins. The glut could last anywhere from
three to twelve more months, depending on the analyst in question. That's
clearly going to hold company earnings down for a while, but aluminum demand
is
measurably improving. So, these companies may be able offset some of those
woes with volume.
Q. Even if
ALCOA aced earnings, were Caterpillar and John Deere the top ways to play
it?
 A.
Probably not. From a technical perspective, CAT and DE were both technically
overbought. From a fundamental perspective, with both CAT (with a current
P/E of 29.11 and a projected P/E of 22.9) and DE (with a current P/E of
28.3 and an aggressive projected P/E of 16.1), it would be hard to justify
prices any higher than where they are now. About the best their investors
could/should have hoped for on Monday was that ALCOA's news would support
the current price.
Q. If not
Caterpillar and Deere, then which industrial machinery stocks are better
positioned?
A. The smaller
ones, from a technical as well as a fundamental point of view.
The nearby table
paints a fairly clear fundamental picture. While some are more attractive
than others, the smaller end of the machinery stocks grid (the list runs
from the largest market cap at the top to the smallest market cap at the
bottom) shows how - on a price as well as earnings basis - they
hold as much if not more value than the large caps in the group. Joy Global
(JOYG) and Bucyrus Intl. (BUCY) are particularly compelling.
Moreover, the
table doesn't quite do these stocks justice; it's based on 12-month data,
but the most recent quarter(s) shows the smaller names in the group are
actually putting up stronger growth and profit numbers than their large
cap counterparts.
On a technical
basis, even if CAT and DE were priced more attractively, those two
stocks are well overbought at the time, and ripe for a wave of profit-taking.
To be fair, some of the smaller names were even more overbought
at the time (in the short run), though at least they justified the runup
with actual results. And, other small caps in the group with great value
had not been pressured higher yet at all. They would have taken some time
and effort to dig up though, so they weren't.
Bottom line?
The small cap industrial and construction machinery stocks are still being
'discovered', which means their trends are essentially still young, not
to mention the fact that they have - by virtue of being small -
potential explosiveness supported by real results. The CAT and DE trends
are likely to be near a point of deceleration, as each company's size starts
to act as a drag on their stocks.
Q. What can
we actually expect from either industry going forward?
A. The notion
that an economic recovery will greatly benefit the aluminum and machinery
industries is accurate. And, since we do indeed feel we're in a recovery
mode, we're bullish on both groups.
 Regarding
the idea that excess aluminum inventory is holding prices down, that's
a legitimate issue, and it can pinch earnings. The assumed degree
of the problem it creates may be slightly overblown though, so we anticipate
aluminum making modest price progress in 2010....perhaps from $1.02/lb.
to something along the lines of about $1.20/lb. It's an important $0.18
to aluminum companies though, and may well represent the difference between
profits or losses.
That said, keep
in mind that even at its 2008 peak, aluminum was priced less than $1.50/lb.,
and
that aluminum was only trading at $0.60/lb. last January. Point being,
prices have already made a big chunk of the rebound they can feasibly make.
Now it's up to the companies and the U.S. dollar [which instantaneously
puts a bullish spotlight on the only listed non-U.S. aluminum company....
the Aluminum Corp. of China Ltd. (ACH)].
As for the construction
and machinery industry, it would be nice if aluminum stocks would rally
side by side with them, but this group doesn't need aluminum to rally with
it - these stocks can and will benefit from the recovery on their own.
As such, we're bullish on this group too... even more so than aluminum
stocks. And don't forget, it's the smaller stocks in the construction and
machinery industry that hold the most potential.
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Updated: 8:42 pm PDT (03:42 GMT), September 7, 2010
