Buy These 4 Stocks Before They Start Rising

Laura is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

I like to analyze what prominent investors buy or sell in the last reported quarter. In this article I detail what Appaloosa Management bought in the past months. Appaloosa was founded by David Tepper, who made $4 billion in 2009 and currently ranks as the 258th richest person in the world. Tepper has earned an international reputation for producing some of the highest returns amongst fund managers on Wall Street.

It’s always interesting to peek into hedge fund managers’ trade book, getting a glimpse of the evolution of their positions quarter by quarter.  In the case of Tepper and Appaloosa, one sees a very fluid portfolio, with high turnover as the size of its positive equity position oscillates dramatically.

Tepper is bullish on the Oil & Gas sector

Appaloosa is quite bullish on big-cap Oil & Gas, which is evident in his new positions in Transocean (NYSE: RIG), Weatherford (NYSE: WFT), Noble and Ensco positions. Oil & Gas represents an important part of Tepper´s new positions in his portfolio.

At the start of the year, Transocean had two interesting catalysts at the same time that led to a quick rally in share price: greater visibility on its Macondo liability and greater clarity on the demands of activist Carl Icahn. I bet that Tepper analyzed both catalysts and concluded that RIG could start a material rally from its consolidation range of $44/49. In fact, on Jan. 3 Transocean announced that it will settle Deepwater Horizon spill case for $1.5 billion, which led to a 20% rally fueled by a rising market.

After the huge rise, Deutsche Bank is not recommending to buy RIG at current valuation levels. Despite a recent update on downtime, yesterday's fleet status report showed a 7% increase in '13 downtime and the first estimate of 2014 downtime is up an additional 5% vs. 2013 (despite a shipyard stay being pulled into '13 and ongoing efforts to improve revenue efficiency). Meanwhile, costs are rising even as rates are flattening. I doubt that Tepper still holds Transocean after the market has already discounted the greater visibility on the Macondo liability.

Despite the volatility in its stock price, Transocean is a very interesting company from a fundamental perspective. The company is the world’s largest offshore drilling contractor and has been focusing on the deepwater drilling market to carve out a niche for itself in the increasingly competitive offshore drilling space. According to Trefis, The Gulf of Mexico is Transocean’s most important geographic market accounting for nearly 20% of overall revenue. The firm has 14 of its 27 ultra-deepwater rigs contracted in the region. These rigs command average day rates of around $500,000 and are crucial to profitability as well since they have higher revenue efficiency (nearly 96%) and better utilization rates. From a long term basis, Transocean could be a winner from a market with that demands deeper dig as less oil is being discovered on land. Given its leadership, Transocean  is currently building more capacity to meet demand.

Tepper also invested in Weatherford, a company that does not show strong fundamentals:

  • Weak Cash/Debt: Weatherford's cash to debt is ranked lower than 87% of the 53 companies in the Oil & Gas Equipment & Services industry
  • Declining gross margin: Weatherford International's gross margin has been in long term decline. The average rate of decline per year is -8%
  • Declining operating margins: Weatherford's operating margin has been in 5-year decline. The average rate of decline per year is -19.1%.
  • Low Piotroski F-Score (a measure of financial strength): Weatherford has a very low F-Score of 3, which usually implies poor business operations.

I do not feel comfortable investing in ¨hard-to-understand¨ businesses that are immersed in operational problems. I think that an individual investor should stay away from these kind of stocks.

I reason that Tepper likes Weatherford for two reasons: 1) Weatherford can embark on its program of a focus on debt reduction, free cash flow, and return on capital and 2) at current prices given its large undervaluation (P/BV of 1x and P/S of 0.6x), the stock is attractive as a takeover candidate. Dahlman Rose considers that Weatherford's core product lines, its global presence, and multinational tax structure would be attractive to a number of companies.

Strong Recovery = Interest Rates go up = Bullish for Insurance stocks

Appaloosa also bought MetLife (NYSE: MET) and Hartford Financial (NYSE: HIG).
Despite that Barclays' outlook is lackluster for the life insurance sector because ROEs are likely to remain compressed due to headwinds from low interest rates and a modest economic recovery, Tepper may think that the economic recovery will continue and the market will start buying Insurance stocks considering a potential change in the interest rate scenario.

MetLife has long had one of the strongest franchises and best recognized brands in the life insurance business. It is a big positive that the company received approval by the Federal Reserve and the FDIC to deregister as a bank holding company. This follows the company's completed sale of MetLife Bank N.A. to GE Capital in January 2013. Now that MET is de-banked and out from under Fed supervision, I expect MetLife to engage in a formal capital management plan that could include a common stock dividend hike and share buyback authorization.

MetLife had a strong Q4 earnings report, beating on both the top and bottom lines, reporting earnings of $1.25 per share, $0.06 better than the Capital IQ Consensus Estimate of $1.19 and revenue growth of 12.3% year/year to $18.36 billion vs the $17.33 billion consensus. Despite the weak interest rate environment, MetLife's business still generates solid returns. Management told investors:

 "Growth was driven by a 21% increase in operating earnings in the Americas and a 26% increase (34% when adjusted for the impact of foreign currency exchange rates) in the Europe, Middle East and Africa (EMEA) segment. Operating earnings in Asia were down 24% primarily due to the annual review of actuarial assumptions."

The stock is undoubtedly undervalued. MET trades at just 0.62 times book value, compared to the P/BV range of 1.2/1 between 2008 and 2010. Moreover, the stock has a forward price/earnings ratio of only about 7x.

In the case of Hartford Financial, the real story is its new capital management plan that includes a $500 million repurchase of common shares and a $1.0 billion debt reduction. While some investors may have been looking for more share repurchases, I believe more will be coming as the company's run-off annuity business rolls off the balance sheet.

Despite trading close to a 52-week high, Hartford remains a compelling value play based on a book value basis. Similar to MetLife, this company should be able to move back to valuations seen in 2010 close to 0.75x book value, a big improvement from the current 0.44x book value.

Overall Conclusion

As Tepper explained in one of his latest appearances in CNBC, he likes to anticipate what the market will do. That is why he has been investing in insurance stocks: as the economy recovers, investors will bet that interest rates will rise which could benefit strong but inexpensive insurers like MetLife. In addition, he is playing the energy boom by betting on several big oil & gas companies. I appreciate you read the article and hope you could get a quick but solid understanding on how a great investor like tepper thinks.

laurapaur2013 has no position in any stocks mentioned. The Motley Fool owns shares of Transocean. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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