Traditionally, today’s earnings release by Alcoa (AA) represents the beginning of earnings season proper. The Earnings per Share (EPS) number will be looked at against a consensus estimate of $0.06, but it is the discussion of the outlook in the subsequent call that is of most interest to market watchers. Alcoa is still one of the leaders in the aluminum market despite a trend toward a lower market share over the last few years, and their estimate of end-user demand for aluminum and aluminum products is seen as a decent guide to the global economic climate. This may be so, but the stock itself is of more interest to me at current levels than any broad impact from their earnings report.
The aluminum market has been in a state of flux recently, with depressed prices and overproduction creating major issues. The company has been through a somewhat transitional period as they increase focus on aluminum products through their “Engineered Products and Solutions” division to offset the resulting weakness in the core refining business. Add to this the evidence of slowing growth in China, and AA has taken a beating this year, dropping from a high of $9.93 in September of 2012 to close Friday at $7.81; a fall of over 21% in a period that has seen the S&P 500 appreciate over 10%. The comparison between AA and SPX gets no better if looked at over a whole year.
Momentum is a powerful thing in markets, but anticipating a shift in momentum can be one of the most rewarding things to do, both financially and emotionally. I am sure there will be those who, reading this, will say that the drop has been justified by market conditions and nothing much has changed; aluminum prices continue to fall, after all, and attempting to catch the proverbial falling knife is a bad habit to get in to.
I do believe, however, that a case can be made for Alcoa stock at these levels. From an overall, fundamental perspective, there are some signs of things improving. June car sales figures released last week indicate growth at the strongest rate in over five years and aircraft manufacturers are also reporting strong demand. Also last week, the Chinese government allowed some easing of rates, indicating a possible return to pro-growth policies there.
Neither of these demand factors is fully developed yet, of course, and supply in the aluminum market is still an issue, despite production cuts by Alcoa and others in the industry. These cuts should, however, soon begin to have an effect and some stabilization of prices, at the least, is to be expected. If everything was in place already, then the price of AA would reflect that. Instead, the fact that the stock is still trading below $8 does offer an opportunity for somebody who is prepared to take a chance.
This type of contrarian trade does involve a significant amount of risk, but if you have been a regular reader you will know that I look at risk in terms of potential reward. If the ratio between the two is acceptable, then the risk is worth taking. In this case, any return above the previous support level of around $8 would clear the way for a significant move up, while a move down to below $7.50 would indicate that further weakness is to come, or that you have bought too soon. This allows you to buy at current levels in front of the earnings with a relatively tight stop around 5% away, looking for a move back up to somewhere around the $9.25 resistance, a potential upside of around 20%.
It is easy to find reasons not to buy Alcoa, and to simply listen to what management has to say for clues as to the overall state of the economy. I believe that doing so may cause you to miss an opportunity. AA may be at a point where momentum is about to shift, and any good news from today’s call could be the turning point.