March 2, 2015
Under $7 Stock's Rebound
Could Land Traders 86% Profits
By Joseph Hogue
Readers of my articles on our sister site, StreetAuthority, know that I have not been a fan of Brazilian stocks over the past 15 months. From my desk in Colombia, I have followed weakness in the economy, as well as in stocks, in Latin America and have called out Brazil twice for being among the worst in the region.
I warned investors to avoid Brazilian stocks in November 2013, suggesting that one company in particular could be hardest hit by the government's micromanagement of the economy. The shares fell 40% over the following four months before recovering on hopes that socialist President Dilma Rousseff would be ousted in the October 2014 elections.
But hope was all it was, and I forecasted that the country's economy and stock market were headed lower. iShares MSCI Brazil Capped (NYSE: EWZ) has fallen nearly 30% since my July call, and my short pick of the group is now down more than 60% since my November article.
Buy When There's Blood in the Streets
While I may not be ready to sound "all clear" on the Brazilian economy, we do not have to time the bottom exactly to benefit from an eventual rebound.
The country's central bank has been aggressively raising rates to tame inflation, which is above 7%. The benchmark rate is now 12.25%, leaving plenty of room to cut if pricing pressures ease. Part of the increase in consumer prices is due to the government's raising of regulated prices on everything from energy to public transportation. This has hit consumer confidence but is a temporary and necessary measure to get fiscal spending under control.
How bad are things in Brazil? Well, corporations there have seen 27 rating downgrades in the first two months of the year. Analysts now expect the economy to shrink 0.5% this year, the deepest contraction since 1990.
Against the nearly unanimous pessimism, investors may want to take a contrarian view. Coordinated monetary stimulus, particularly from the EU, could help boost global growth. Brazil's economy is closely tied to commodity prices and could be helped by a rebound. And strict fiscal tightening should improve the budget deficit and slow the pace of credit downgrades.
The stock I highlighted in previous articles as one of the best short candidates could also offer the biggest upside potential on a turn in the economy or sentiment.
I have called Petrobras (NYSE: PBR) a state-controlled piggy bank and worse in the past, but the 60% drop since my November 2013 analysis is overdone.
The resignation of CEO Maria das Gracas Silva Foster, along with five board members, in early February is a good step toward restoring investor confidence. The new CEO, Aldemir Bendine, a veteran of the banking industry, was brought in to cut costs and build faith. If Bendine follows the same playbook he used at Banco do Brasil, he will divest non-core assets to raise cash. This could go a long way since the company is expected to face a significant writedown following the corruption scandal.
The near-term struggles at the company mask some of the best long-term potential in the industry. One of the world's largest deep-water oilfields was discovered off the coast of Brazil in 2007. The news sent PBR rocketing from below $30 to over $70 by May 2008. Total potential reserves in the pre-salt formation have been estimated at 80 billion barrels of oil equivalent.
The company's breakeven range for pre-salt projects is between $41 and $57 a barrel, well below the current price of Brent crude and lower than the price needed by many shale projects in the United States. Even as non-traditional production is cut due to lower prices, production at pre-salt fields should remain profitable.
Currently, the country produces more than 600,000 barrels a day (bpd) from pre-salt projects, just over a quarter of total production. Estimates of the area's potential take production all the way up to more than 2.1 million bpd by 2020, which would go a long way in halting the production slide that helped lower investor confidence in the country.
On this strong long-term potential and the possibility for near-term upside from asset sales and cuts in capital expenditures, shares of Petrobras are starting to look attractive. They trade at just over 6 times trailing earnings, the lowest among the 16 integrated oil companies tracked by Morningstar.
Analysts currently see 2015 sales falling 19% to $111.6 billion and earnings dropping 3% to $1.22 per share. Any recovery in sentiment could boost the price multiple closer to the industry average of 10.6 times earnings and send shares sharply higher.
While PBR fell dramatically last year on the bribery scandal and the tumble in energy prices, this year has seen shares bottom around $6 with several runs back above $7. I expect shares to trade to $8.54, which would be 7 times 2015 forecasted earnings.
When the potential for a near-term recovery presents itself in a stock with good long-term support, I often use call options to decrease risk and amplify profits. Using a call strategy, we can turn the 28% move in the stock into an 86% return.
PBR Call Option Trade
With shares of PBR trading for $6.63 at the time of this writing, I am interested in buying PBR Jul 5 Calls for a limit price of $1.90 each.
This call option has a delta of 82, which means it will move roughly $0.82 for every dollar that PBR moves, but it costs a fraction of the price of the stock.
The trade breaks even at $6.90 ($5 strike price plus $1.90 options premium), which is 4% above current prices.
If PRB hits my $8.54 upside target, the call options will be worth at least $3.54. Once you enter the trade, place a good 'til cancelled (GTC) order to sell your calls at that price.
Recommended Trade Setup:
-- Buy PBR Jul 5 Calls for $1.90 or less
-- Set stop-loss at $0.90
-- Set price target at $3.54 for a potential 86% gain in 4.5 months
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