Unusual Opportunities In Alcoa
Summary Mar. 15, 2015 6:00 AM
Statistically speaking, two key factors indicate that it is time to buy Alcoa.
Fundamentally, Alcoa is a strong investment, but beware of developments in energy and the dollar.
Avoid the "analysis fallacy" - stick with something simple.
Since November, Alcoa (NYSE:AA) has been hammered with a 20% decline in stock price. For those just waking up, a stream of downgrades, a slight shift in business model, and declining oil prices have driven a fairly-strong decline over the last 4 months. While these factors are important to watch, they have been decently rehashed by several analysts. In this article, I will step back from the short-term headlines and take a look at 20 years of business cycles for Alcoa to provide historical perspective on the recent developments.
Weekly Declines
What immediately crossed my radar as I began researching Alcoa was the fact that the recent selling pressure in the security has been unmitigated for over a month. In fact, for the past 5 weeks, Alcoa has declined during trading throughout each week for a fall of almost 20%. The fundamental catalysts for this decline have been spending cuts in refining and smelting, as well as a few downgrades and continued pressure on oil. If we step back from the immediate fundamental picture, we can statistically analyze the recent decline in Alcoa and put it into a 20-year perspective.
Over the past 20 years, Alcoa has only experienced 23 time periods when price has fallen for 5 consecutive weeks. In the chart below, it can be seen that historically speaking, Alcoa typically strongly rebounds following similar movements.
Markets ebb and flow and fundamentals are always changing. But historically speaking, we've been here before with Alcoa. And it rarely ends nicely for the bears. If the past is a rough guide to the future, there is around a 70% chance that price will rally over the next 3 months. In fact, if one were to buy now and hold for 3 months, on average, shares return 8% following similar declines.
Intensity of Move
Another unusual development in Alcoa is the fact that the recent move has been very compressed. What I mean is that over the past few weeks, we have had a very strong selloff, historically speaking, for this stock. Again - we've been here before and these movements statistically are not followed through with further declines. The chart below shows what has historically occurred in Alcoa's stock following movements of this intensity over the past 20 years.
This is where the statistics get really exciting (if such a phrase can exist). Since 1985, we've had 33 similar selloffs in Alcoa's stock. In 69% of these occurrences, price has rallied by an average of a whopping 39% over the next 12 weeks. The data suggests that if the past is to be a rough guide to the future, we have a decently strong chance of seeing Alcoa make new highs over the coming months.
Fundamentals
Fundamentally speaking, Alcoa is positioned nicely for its historic statistics to play out once again. With a 14% year-over-year revenue growth and a decent 9.6% operating margin, Alcoa is a decent investment. However, there are a few factors which truly could throw-off the statistics:
Further declines in the energy sector could significantly impair operations - keep an eye on the price of crude while making your investing decisions
Current P/E ratio of 66 - granted, this figure is thrown off by the recent volatility in earnings, this is still very expensive
Continued strength in the dollar - commodities have been hammered lately due to a rise in the dollar. The commodity sections of Alcoa will be no different - be mindful of this when making a final investing decision
These factors can't be holistically backtested and true due represent a threat. When purchasing or holding Alcoa, keep an eye on the commodity prices of energy, the current P/E ratio, and strength of the dollar.
Simplicity
"But wait," you say, "what about smelting? What about refining? What about the business model?" My answer to this is fairly straightforward - we've been here before! This is the cusp of this analysis. The only difference between now and the past two decades is the headlines. Businesses ebb, flow, and move in cycles. This isn't the first decline for Alcoa, and I believe a healthy dose of perspective can help the panicked investor evaluate the security.
If you are still skeptical that simple statistics can guide investing decisions, then I believe an understanding of the analysis fallacy is in order. Simple stated, the analysis fallacy is the belief commonly held among investors that the more complicated and sophisticated a story, the better chances it has of being correct. In other words, if I wrote an essay about smelting, refinery crack spreads, and the economics of purchasing manufacturing steel and tacked on a "buy!" recommendation, many people would believe me.
The problem with this thinking is that it ignores the simple rules of conditional probability. Basically, the more conditions and steps you apply to your analysis, the less accurate it will ultimately be according to the laws of probability. Here's an example.
In this example, the analyst thinks that there's a 70% chance that sales will increase. The analyst believes with 70% confidence that with this increase in sales, the firm will be able to contain expenses so that profit rises as well. If these two things occur, then our analyst believes that there is a 70% chance that share price will rise in response.
At face value, this sounds great. We have a 70% chance of being right in several areas of our forecast! Unfortunately, that's not how probability works. The more complicated your analysis, the less likely you will be correct. For this analyst who is pretty confident in his stuff, statistically, he will only be right 34% of the time. You're better of flipping a coin.
Back on Topic
The reason for saying all of this is that I have presented a simple analysis of Alcoa based on statistics. This analysis is very straightforward and frames the recent events in light of history. I believe that two separate statistical measures of security price indicate that we are in for a strong rally in the immediate future. For this reason, I suggest purchasing the stock.