The Art of “Buying Low”

PLAY: Buy the VLO January 35 Calls (VLO AG) at market, good for the week. Place a protective stop limit at $2.30 and implement our scaled-selling technique to lock in portions of your profits as these calls achieve 50% returns (and greater).

Dear Bottarelli Research Member,

We witnessed a major money flow transition this week, as money moved out of oil, energy, and commodities and into financials and housing.

For the better part of two years, the play was to short housing and financials and buy oil, energy, and commodities. But over this past week, this position completely reversed course.

The trigger for this reversal was two-fold. First, news from Wells Fargo (WFC – NYSE) and JP Morgan Chase (JPM – NYSE) helped alleviate some of the fears in the financial sector. This alone helped the major market averages take a major sigh of relief. Secondly, oil prices made an aggressive move lower, and this offered pricing relief as well.

Now that this money transition has occurred, the big question will be whether or not it’s sustainable. Do the markets trust that the banking woes are over? And do the markets trust that oil prices will remain under $130 per barrel?

These questions will undoubtedly surface next week — and continue for the remainder of the summer. But I’ll answer them for you right now.

In terms of the banking question, you should expect more weakness ahead. WFC and JPM are two of the three strongest financials out there (with Goldman Sachs being the third), so this past week’s move was simply two financial leaders flexing their muscle. The weakest banks still are in dire shape, and they’ll continue to suffer (or fail) in the weeks and months ahead.

In terms of the oil question, we will continue to see volatile intra-day moves. For example, you often see oil prices gap up $3.00 in the morning and then end down $2.00 by the close. In fact, crude’s $16.00 price drop this week was the largest three-day drop in history. These intra-day price swings will continue to spark nervous trading in the commodity sector, including coal, steel, agriculture, oil service, and energy. Today’s LEAPS play will capitalize on this so-called “nervous” trading.

During these inevitable price swings, it’s critically important that we, as longer-term LEAPS investors, keep our wits. While I admit that it’s been frustrating to watch some of our positions drift lower even as the markets are rallying, I remain confident that we own positions in strong, solid, and profitable companies that will recover well before their respective expiration dates. Market environments like this are exactly why we buy extended expiration dates, and I remain bullish on every single one of our longer-dated call plays. In fact, a recent article by CBS Market Watch’s Irwin Kellner describes this mentality perfectly.

He writes, “Buy low, sell high. You don’t have to be a stock market expert to figure out that this is the way to make money in the market. Unfortunately, many people have lost sight of this rule of thumb. They like to buy when prices are high -- and wind up selling when prices are low. I can’t tell you how many people have asked me within the past few weeks if they should get out of the market, now that prices have fallen. It’s hard to blame them for this attitude. If their holdings merely mimic the major market averages, they most likely have seen lots of paper profits disappear under the onslaught of the 20%-plus drop in stock prices from their October peaks. This has many investors on the verge of panic.”

His commentary continues, “The big money is made when you’re a buyer and everyone else is selling. I know that trying to catch a falling knife can be hazardous to your health. But there’s always the possibility that the crowd is wrong, so judicious buying at times like these could prove to be rewarding. As for your current holdings, all I can say is that if you liked a stock when it was selling for $20 a share and the company is still making money and paying the same dividend, you should love it at $10 -- and be absolutely nuts about it at $5 a share”

This perfectly describes the situation we find ourselves in with some of our LEAPS positions. Take the Hovnanian January 2010 12.50 Calls (YZX AV), for example. We liked this longer-term position back on June 4^th for $2.00 per contract. So when it dropped to under $1.00 last week, we added to our calls for $0.80, lowering our total coast basis down to $1.45. Then on Thursday, HOV engaged in a two-day rally that pushed these calls up to $1.55, quickly turning a losing position into a 6.90% gainer. And since we have until January of 2010 on this position, I expect much higher gains to come.

This price action on HOV is a crystal-clear illustration of just how quickly our LEAPS positions can bounce back. The trick is sticking to our convictions and giving these plays time to mount their recoveries. I admit, it’s quite difficult sometimes. After all, the market will challenge you, mess with your emotions, and tempt you to sell. But I’m here to help you avoid this trap. We’ve done our homework, and we know that the companies we own are strong. A low market tide has pushed some positions lower across the board, but the waters cannot stay this low for long. A rising tide is coming soon, and when it does, we’ll look back at June and July of 2008 and call it one of the best buying opportunities of the year.

So on that note, I’d like to introduce you to today’s newest LEAPS pick, Valero Energy (VLO – NYSE).

Valero Energy owns and operates 17 refineries located in the United States, Canada, and Aruba that produce conventional gasoline, distillates, jet fuel, asphalt, petrochemicals, and lubricants. Their principal product includes conventional gasoline, which they sell using 5,800 retail and wholesale outlets under the brand names Valero, Diamond Shamrock, Shamrock, Ultramar, and Beacon. As you can see below, the stock has gotten absolutely bludgeoned lately:

The reason for the weakness is simple. You see, VLO does not own any oil reserves, so they make money by purchasing crude on the open market and refining it into gasoline (and other distillates).

From a profit perspective, VLO’s earnings can absolutely explode when they can purchase oil, refine it, and sell it at a higher total cost to the consumer. But with oil prices hitting north of $140.00 per barrel, their pricing power has taken a major hit.

Over the past 12 months, for example, crude oil has increased 91%, but unleaded gasoline has only increased 54%. Therefore, the “crack spread” (which is what floor traders call the profit spread from distilling crude into heating oil and gasoline) has shrunk by a dramatic 35%. As a result, shares of VLO have lost -57.30% over the last 52-weeks, far out-pacing the -19.42% decline of the S&P 500.

Based on this situation, why in the world would we add VLO calls to our ledger?

Well, the answer is simple. If oil prices tick down, even by a little bit, shares of VLO will blast off. And this week, as noted above, oil prices had their largest three-day drop in history. This could indicate that oil’s high price of the year has been set. If this is true, and oil prices do indeed stabilize, then we could have the buying opportunity of the decade on VLO.

Just consider these numbers and you’ll see what I mean…

As you read this, VLO is worth more than $10 billion, yet it trades at the bargain-basement P/E ratio of 4.40. This is absurdly cheap for a company of this size. As a point of reference, Exxon Mobil (XOM – NYSE) has a current P/E ratio of 10.45. And while 10.45 is an extremely attractive ratio in its own right, it goes to show you that VLO could double in price and still remain “attractively valued” compared to its peers.

With trailing three month revenues of $103.72 billion on severely reduced profit margins of 4.20%, the market is completely focusing on the negative aspects of VLO. That’s why shares are trading for such a reduced price. But if (or when) the oil market stabilizes, VLO has uncommon potential for a major upside rally. In fact, when I discover risk versus reward imbalances that are so skewed to one side, it creates an ideal opportunity for a new LEAPS play.

In other words, with the market focusing solely on VLO’s current “crack spread” troubles, it fails to recognize any earnings potential once this spread reverts back towards the historical mean. Any improvement, however small, will result in a sharp upward price move in VLO. If you look at the numbers, you’ll see that things can improve faster than you would expect.

Case in point, Valero’s 2009 earnings are expected to swing from a -43.3% decline in 2008 to a +24.4% increase in 2009, yet this dramatic earnings recovery has not been reflected in VLO’s current stock price. As these improved numbers are reported, I feel that VLO is due for a major snap-back, and we want to profit off this move using VLO LEAPS.

PLAY: Buy the VLO January 35 Calls (VLO AG) at market, good for the week. Place a protective stop limit at $2.10 and implement our scaled-selling technique to lock in portions of your profits as these calls achieve 50% returns (and greater).

UPDATES

DECK September 90 Puts (QUK UR): One of our newest downside market picks handed us a quick 44% return, and therefore we sold half of the position earlier this week. That leaves us holding the remainder of our position, which is currently trading at our exact entry point. If this position moves back to a 50% return (or greater) next week, be sure to lock in the remainder of your profits.

CRM November 55 Puts (CRM WK): The second of our newest downside market picks has drifted along without making a strong upside or downside move. Continue to hold these puts, and lock in a 50% return if prices move on our direction next week.

VIX October 25 Calls (VIX JE): Our hedge against further market volatility continues to do its job, so maintain this protective volatility hedger for more upside.

PBR January 90 Calls (PMJ AR), FWLT November 75 Calls (UFB KO) & RIO January 37.5 Calls (VOH AU): When I made reference to “buying low” in my commentary above, these three positions immediately come to mind. I continue to love all three companies even though their stock prices remain stuck in the mud. As we’ve seen with HOV this week, our LEAPS can make swift recoveries, and I expect to see similar upside recovery swings in all three positions coming soon. Therefore, maintain all three positions.

OSG January 95 Calls (OSG AS) & WFT January 2009 50 Calls (WFT AJ): Here are two picks on the verge of profitability. Continue to hold each pick, and be sure to lock in a 50% return on any pops next week.

AMX January 2009 70 Calls (AMX AN) & HOV January 2010 12.50 Calls (YZX AV): Our two super-low priced LEAPS have each made nice recoveries this week, which indicates that the bottom could be in for each stock. Maintain your LEAPS for extended gains.

Potential Future Play:

Another big-time buying opportunity could be found in shares of Archer-Daniels-Midland (ADM – NYSE). Similar to VLO, rising corn prices have cut into ADM’s margins, but if commodity prices begin moving down, this could trigger a tremendous upside pop in shares of ADM. Therefore, I’ll be closely watching this one for a possible LEAPS pick in the future.

And until we talk again, have a great weekend.

Sincerely,