Undervalued Stock's Chart Signaling a 'Buy' That Could Return 140%
Value investors can trace their roots to Benjamin Graham, who developed a number of techniques for finding stocks trading below their fair value. Some of those techniques required a detailed analysis of the company's financials, but Graham also advocated a relatively simple approach. He felt that any company trading at a price that is less than the value of their cash holdings is a buy.
That's the first thing we noticed about the company we want to discuss today – its balance sheet shows $3.24 billion in cash, or $11.33 a share, which is greater than the stock's price.
It's always best to look at a stock like this closely, because this is where a value trap can develop. Investors can get trapped in a stock that's falling because they think the valuation looks good, when there are deep-seated operational problems.
Some companies have high levels of cash because investors keep it afloat with new equity investments or loans. To guard against that, we look at the statement of cash flows, and for this company, we discovered that cash flow from operations is positive.
The next step is to check earnings. This company has actually grown earnings per share (EPS) at an average annual rate of more than 25% in the past five years, and that is expected to accelerate to almost 30% a year in the next five years.
With so many positives, it looks like E*Trade Financial Corporation (NASDAQ: ETFC) is undervalued after recovering from a brush with disaster during the financial crisis. Like many other financial firms, ETFC had problems with mortgages and derivatives that led to losses beginning in 2007. But the company's management has a plan to continue cleaning up the balance sheet and increase the future profitability. In fact, during the company's last quarterly analysts' call, management showed how earnings could be increased 10-fold in the long term.
In 2013, analysts expect ETFC to report earnings per share of $0.54, reversing a loss of $0.39 in 2012. In 2014, EPS is expected to reach $0.66. The company seems to be significantly undervalued if it can meet expectations.
The value trap we mentioned earlier can often be avoided by applying technical analysis. Undervalued stocks will remain undervalued until investors start buying them, so we turn to the chart to see whether other investors are buying. Chart patterns and technical indicators should be bullish before we buy, and the weekly chart of ETFC supports buying now.
ETFC has been forming a double-bottom pattern for most of the past year. Relative strength (RS), shown at the bottom of the chart, tells us ETFC is among the strongest possible investments right now. Recent price action has pushed the stock out of the bottoming pattern and the target of $14.24 is more than 30% above the breakout point.
The question investors should consider is whether ETFC can fully recover from the effects of the financial crisis. Management seems to have a plan in place and is focusing on their core business. The number of brokerage accounts is growing, as are the assets in those accounts.
In addition, the company is increasing its retirement accounts business, holding the accounts of individuals covered by retirement plans. This money tends to be held for the long term, and although the annual fees are low, a large amount of assets in this business can help the company steady profits. ETFC is also executing more trades as a principal, profiting from the spreads customers pay, and that too should help profits over the long-term.
ETFC is trading at less than two-thirds of its book value and for less than the value of the cash on its balance sheet, and its chart is bullish. Many readers have undoubtedly considered E*Trade as a broker, and they should also consider E*Trade stock as a potential buy right now. For more speculative traders, call options could be used to leverage the expected gains.
Recommended Trade Setups:
-- Buy ETFC at the market price
-- Set initial stop-loss at $9.37, the lower Bollinger Band on a daily chart, and trail the stop higher with that indicator
-- Set initial price target at $14.20 for a potential 30% gain in 6-12 months
-- Buy ETFC Jan 2014 12 Calls at $1 or less (this long-dated option allows time for the turnaround)
-- Do not use a stop-loss; invest only an amount you can afford to lose
-- Set initial price target at $2.40 for a potential 140% gain in 11 months