Digging Up Value

 | Jan 21, 2014 | 2:30 PM EST
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Besides watching some great football games Sunday and consuming entirely too much fried food, I spent a good deal of time over the long weekend reviewing market underperformers of 2013. Being a contrarian investor, I find this to be a good hunting ground for undervalued names that the market is not paying much attention to. I have found investor sentiment to be fickle, and these types of plays can easily outperform the overall market if the outlook on these stocks improves just a bit.

Mining and materials were not the place to be in 2013, and the sector has myriad names that can have much better years with any improvement in sentiment. Aluminum producer Alcoa (AA) is one name that is already starting to move. Jim Cramer noted recently that the stock shrugged off a recent earnings miss and actually moved higher.

The company is well managed and is cutting capacity in areas of its smelting footprint where it is no longer cost competitive. Alcoa should also benefit as some of its specialty products see much greater demand in auto production as carmakers use aluminum to cut weight and increase gas mileage.

Aerospace is another booming industry that is seeing increasing demand for Alcoa's lightweight aluminum alloys. The company should also benefit greatly when Europe turns around. As inventories are worked off, any price increases could have a massive impact on cash flow and earnings. Even with the stock's recent run, it is still 40% lower than its highs in 2011.

Probably the ugliest subsector in mining over the past two years has been the gold miners, which have had significant declines even as the market has shot up. These miners are finally reacting to the substantial decline in the price of gold. They are cutting costs, closing marginal mines, reducing or suspending dividend payouts and cancelling new projects. Consolidation also seems to be accelerating recently in the sector.

I like Barrick Gold (ABX) as a proxy for any kind of improvement in the sector. Some large investors have targeted the shares; two directors have resigned, and there's an agreement for the departure of the company's founder and longtime leader, Peter Munk. It has stopped development at its huge project at Pascua-Lama in South America and raised about $3 billion in October to shore up its balance sheet.

Any improvement in sentiment on the gold miners and/or an increase in the price of gold could have a powerful impact on Barrick's stock price. At Friday's close of $18.17, the shares sell for nearly a third of their highs of just two years ago. Barrick goes for approximately 10x forward earnings and just over 4x operating cash flow. The stock also goes for just over 4x its 2011 earnings.

I own both names through long-dated, out-of-the-money, bull-call spreads. I use this strategy consistently for cyclical plays like these. It keeps losses low if sentiment does not improve in the stock or sector I am targeting. If a turnaround does indeed occur, the strategy leads to outsized gains.



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