Cummins Engines is the comeback king, the little engine that could, if you will. Check out its major comebacks in the past year after earnings and guidance disappointments:
I’ve circled in red the major earnings misses over the past year, all coinciding with large volume spikes (lower panel), but all turning out to be capitulation points in hindsight. The most recent case was its earnings announcement on Apr 30th, after which the stock promptly bounced right off of its 200 day moving average.
I’ve had some success trading CMI this year (see trades here and here), but the stock’s ongoing strength has been especially perplexing to me. Here’s why I’ve had a short bias:
- Earnings contracted 5% in 2012, and are expected to contract another 5% in 2013. Yet, the P/E multiple has actually expanded from 10 to 15x in that period, quite a leap of faith by investors.
- CMI has failed repeatedly at the 120 level over the past 3 years, so I like entries on the short side when the stock gets near there. Moreover, the fundamental picture now is worse than it has been at other times in that period.
- Chinese growth continues to disappoint. Here is the Citigroup Economic Surprise Index for China over the last year, with the 0 level marked by a red line:
Citigroup Economic Surprise Index for China over past year, Courtesy of Bloomberg[/caption]
Cummins gets 60% of its revenues from outside the U.S. A large part of that industrial demand is driven by demand from China or related countries (like Brazil, whose growth is directly tied to China’s). Chinese economic weakness has hurt Cummins earnings (as exhibited by 2 straight years of declining numbers), but investors have continued to give this company a pass. Valuation at 15x is no bargain either.
Add it all up, and this is another good entry for a short-biased trade in CMI.
TRADE: CMI ($117.05) Bought the July 115 / 105 Put Spread for $2.70
-Bought 1 July 115 Put for 3.75
-Sold 1 July 105 Put at 1.05
Break-Even on July Expiration:
-Profits btwn 112.30 and 105, make up to 7.30 with max gain of 7.30 at 105 or below.
-Losses of up to 2.70 btwn 112.30 and 115 with max loss of 2.70 at 115 or higher.
Risk Chart
[caption id="attachment_26232" align="aligncenter" width="619"]
from TradeMonster[/caption]
Trade Rationale: CMI can move very quickly in both directions, so I wanted to do a long premium trade, but out to July, which should give me enough time to capture a decent sized down move in the name. The ideal target for the trade is the 200 day ma, now around 106, but of course I will be watching how the stock acts in the interim.