Analysts have myriad motivations for the brass who pay their way, but among their duties is not when you should buy or sell. Simply, when analysts sell, look for opportunity to buy. The corollary may often be true, but buying timely will set up our eventual exist and a successful trade.
Neither all equities are equal, nor are the catalysts that can set their price backwards. Last week, like most earnings weeks, delivered a number of ‘surprises’ that beat down share prices of quality companies into the value category. Some may argue the very notion was improbable as the indices surged higher, but value oriented investors must look for the sale isles.
Simply too compelling to pass up, Cummins Inc (CMI, Financial) flashed across my screens. I have four, so this lit up my radar. There were other opportunities too, but let’s focus on CMI because I had let this one get away late last year.
We all know Cummins makes diesel engines for everything truck. It also manufactures electric power generation systems and is a technological leader in engine component products and overall performance (emissions, power, and reliability). Less known is that CMI operates in 160 countries via a distribution network of 550 distributors and 5,000 dealers. CMI generates 52% of its sales overseas. Its leadership position affords CMI unique advantages above competitors.
More that’s under the hood:
Under that banner, was it a surprise CMI sales could be pressured with a high dollar? Comparatively, 33% of the S&P500 revenues are made overseas (Goldman Sachs 2013) so this was a known exposure. Europe remains a mess, China leveling on a macro level. There was plenty to be cautious about heading into earnings Thursday. But CMI still managed to beat y-o-y earnings. For the quarter: CMI reported $444 million & $2.44 a share, up from $432 million & $2.32 a share. Excluding one-time expenses, earnings per share were $2.56, beating analysts’ forecasts of $2.51 a share. Top line revenue improved 11% to $5.09 billion on the quarter and full year CMI delivered over $19 Billion vs $17 Billion the year before. 11% top line growth in a world struggling to deliver anything positive in GDP screams of someone doing something right.
Regardless, analysts couldn’t resist running for cover (8 of 24 to be exact; reduced forecasts). CMI sank 3.5% on Thursday and gave back more in a volatile tape on Friday, closing the week at $135.86, approximately $10 off the close before its earnings call. A novice will easily notice the nadir last October at $124. Then the global wheels were coming unglued and turmoil scared the bravest who claimed emboldened. Hind-sight to that frightful day, we’re all kicking ourselves for not loading our Cummins’ powered trucks with all the equities we could carry.
The Trade and How to Express your Opinion:
Careful not to chase, we got a second chance IF we structure our trade correctly. An investor with excess liquidity could buy CMI outright. At $135+- and a rock solid dividend recently raised to $.78 ($3.12 paid quarterly) is a yield of 2.3%, comfortably above its historical yield of 1.8% and far better than from Uncle Sam’s 10 year. CMI’s payout ratio is below 30% (dividend / earnings) and management’s commitment to keep its shareholders remunerated offers more assurance. Note, in 2009 when everything torpedoed, CMI raised its dividend, then $.70/share.
Adding to opportunity, CMI board at the same time it boosted shareholders’ dividend (summer 2014) also added $1 Billion to its share buyback, of which it deployed at least $670 Million. Lastly, CMI’s solid balance sheet gives management lots of leeway, snap shot courtesy Valueline:
Alterative Investment:
Or use options: considering implied volatility remains higher than historical make CMI an ideal case for Put writing. Following is a 2 year chart courtesy of LiveVol. You’ll see 360 day options implied volatility is higher than historical volatility notwithstanding last October. Even post earnings and after the post earnings pummeling, translation: long dated option sales are more advantageous than similar option purchases.
Importantly, I look to write the longer term January 2016 Put at a strike that balances my personal risk tolerance with my thesis to profit. Many will argue a shorter term contract yields faster ‘theta’ (time decay), but closer analysis reveals Implied Volatilities LOWER than Historical. That means BUYING short term options would be more advantageous than selling. But I very rarely ever buy short term options, especially OTM. These are fools errands to lose money; I’d be happy to answer questions on this, but I digress.
Returning to CMI, shorter term option sales also leaves us exposed to an ‘If Put’ cost basis that is higher than I prefer. Remember that nadir in October? We all aspire to be so good to call the bottom. With Options, we can! Specifically, the January ’16 $135 Put offers us $13.70 premium (see the trade bar courtesy ThinkorSwim) and a cost basis at $122.16 (strike less premium received)! Recall that fateful October revealed a bargain bottom at $124.30. Using options we’ve engineered a cost basis even better. Further, we have a margin of safety that is 9% below the current bid ($135.86).
It’s important to note the long thesis behind CMI verse merely an option premium collections strategy (particularly one that’s clipping short term contracts). The later will eventually bury the loftiest account. If you are not comfortable owning CMI, watch from the sidelines; however note that cash on the sidelines is an investment--a bad one that comes with a negative real yield (interest below inflation).
Disclosure:
Short CMI options. The foregoing are not intended to be specific investment advice, but concepts to consider when investing. Consult your Investment Adviser.
