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Investors often make one key mistake: They look to bag profits after an investment has made an impressive move. That makes sense — if the reasons to buy that stock have changed, or if the stock is now too pricey in relation to future earnings. But there are many instances where you should “let your winners ride.” Rising stocks can often stay in an up mode for an extended period of time, which is why many investors seek out just such stocks, using the Relative Strength Index.
I’m not a big chart reader and tend to avoid chasing momentum stocks. But I know a bargain when I see one. And Alcoa (NYSE: AA) still looks like a very attractive stock, even after a 40% gain since I recommended the shares four months ago.
As I noted back in September, Alcoa’s 2009 results were nothing short of dismal, as sales fell 31%. Thanks to robust cost cuts and an uptick in aluminum prices, 2010 results were notably better. Sales rose 14% and cash flow more than tripled. Alcoa finished the year with solid momentum, and sales should rise another 15% this year while cash flow could rise at a triple-digit clip once again. Rising demand for aluminum in automobiles, beverage cans, airplanes and global construction should set a positive industry tone, more than offsetting a moderate rise in industry capacity.
Yet many analysts continue to be unimpressed by Alcoa, noting that shares seem fairly valued in the context of projected 2011 results. They’re right. But now that we’ve turned the calendar into 2011, and now that the global economy seems set to finally strengthen in the next few years, you have to look out to 2012 and 2013 to really understand the value of this stock.
[More from David Sterman: "The 5 Most Valuable Stocks on the Planet"]
My bullish long-term view comes down to China. Aluminum smelters consume massive amounts of electricity, and as a result, China has realized that its energy production is better spent in other areas. The country has been taking steps to discourage domestic production of aluminum as a result. That means China is now a net importer of aluminum whereas it was a net exporter of aluminum in the past.
Meanwhile, Alcoa’s previous strategy of putting smelters where clean low-cost energy is abundant in places like Iceland and Trinidad/Tobago is now paying off. The company is the lowest-cost producer in the industry — by a considerable margin.
Analysts currently think Alcoa will earn around $1.15 this year and $1.45 in 2012. Then again, they’ve been under-estimating the company’s earnings potential for several quarters now, and I think those forecasts are too conservative. Regardless, you need to see the stock in relation to where profits can ultimately reach in the whole economic cycle. By 2013, further modest top-line growth could push EPS toward the $2 mark, and EPS could hit a cyclical peak of around $2.50 by 2014. (As a point of reference, Alcoa earned $2.54 a share in 2006 and $3.24 a share in 2007).
Action to Take –> What I wrote four months ago still applies: “When the global economy — and Alcoa — are back on their feet, shares could easily trade up to 10 times profits (or six times 2013 EBITDA), or $22 to $25.” That’s another 40% from current levels, though still below the $30 to $40 range seen in 2006, 2007 and 2008.”
Shares moved up by that amount since last September. I think another 40% move is in order for the stock, though I suspect that this next move could take a year or two to play out. Lastly, once Alcoa addresses its underfunded pension, the firm will likely look to reinstate its dividend back to levels seen a few years ago — $0.60 a share. That equates to a yield of roughly 3.8%.
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