Unlikely Value Stock Could Land Traders 250% Profits

After such a long bull run, trying to find a good deal in this market is like going shopping at a store on the last day of a month-long sale. 

Many investors believe value has all but disappeared, but there's one sector that's been ignored by the majority and offers an opportunity for astute investors.

Thanks to strength in equities and the U.S. dollar, commodities have been getting crushed. This, of course, won't be the case forever, and not all commodities should be treated equally. 

Steel has been thrown to the bears this year thanks to demand fears related to a slowing global economy and a precipitous drop in the price of iron ore, a key ingredient in steelmaking. 

The Market Vectors Steel ETF (NYSE: SLX) is down 17% year to date, and its Relative Strength Index (RSI) is hovering near oversold levels.

SLX Chart

According to the World Steel Association, global steel demand is expected to increase 3.1% this year. This is down from last year's growth of 3.6%, causing many to abandon the sector. But slowing growth is not negative growth, and demand is expected to rise by 3.3% in 2015.

Iron ore prices have dropped dramatically. They hit a five-year low near $75 a ton this week on news that China was curbing steel production as surpluses mount. But some analysts are forecasting a rally, with UBS (NYSE: UBS) projecting iron ore prices at $100 a ton by year end just a few weeks ago.

Despite the slowdown in China, the country is actually importing record amounts of iron ore. As prices react, steel stocks shouldn't be too far behind. And as China pares back steel production, demand should begin to pick up.

Despite the challenges in the sector, United States Steel (NYSE: X) has been crushing earnings estimates, beating expectations by an average of 115% in the past four quarters. It has also doubled the performance of the broader market with a year-to-date gain of more than 30%.

X Stock Chart

In the most recently reported quarter, net income increased 88% with losses narrowing to $207 million, or $1.42 per share, from a loss of $1.8 billion, or $12.38 per share, a year ago. Barring non-cash charges for strategic actions and gains from asset sales, the company earned $2.16 per share. Analysts had only been expecting $1.18 per share. Revenue also exceeded estimates, growing 11% year over year and much higher than the industry average of 0.8%.

Considering the company's strong performance when commodity prices have been pushed lower thanks to economic fears and a strong U.S. dollar, X looks like a bargain. 

Analysts at Nomura estimate 2015 EPS of $5.35 and said they believe 10 is a fair P/E multiple. This would put the stock's fair value at $53.50, although their target is higher at $60.

Using the more conservative target, this means X is trading at a 48% discount. With a call option strategy, we could leverage the stock's potential upside into triple-digit profits in just a few months.

Today, I am interested in buying the X Apr 36 Call for $5 or less ($500 per contract).

This trade breaks even at $41 ($36 strike price plus $5 options premium), which is about 14% above recent prices, but well below our fair value target. If shares hit $53.50 by expiration in April, then the call option would have $17.50 of intrinsic value and deliver a gain of 250%. The most we can lose on this trade is the $500 per contract we paid.

The longer-term call option should be able to weather short-term volatility while taking advantage of the turnaround predicted in steel prices. 

Recommended Trade Setup:

-- Buy X April 36 Call for $5 or less
-- Do not use a stop-loss
-- Place initial price target at $17.50 for a potential 250% gain in five months

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