Value Can Be Deceiving and Traders Can Benefit from That
Sometimes, stocks with low price to earnings (P/E) ratios have low P/E ratios because they offer value. At other times., the low P/E ratio is a value trap. One example of the latter case is found in news that Benzinga recently reported, “Memory and storage solutions company Micron Technology, Inc. (NASDAQ: MU) reported … fourth-quarter results and a disappointing outlook.
Micron shares immediately traded lower following the print, and the Street debated if investors should be buyers of the dip.
Micron reported a top-and-bottom line beat in the fourth quarter.
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The DRAM business showed an approximate 1% sequential revenue increase, and NAND revenue was up 5%, RBC Capital Markets analyst Mitch Steves said in a note.
Bulls can look at the print and conclude the company is “past the bottom” on NAND, while DRAM is starting to bottom, the analyst said.
On the other hand, bears will continue highlighting Sino-American trade tensions, especially the Huawei ban, he said.
This implies the sector is not only “un-investible,” but there is “no line of sight to a clear recovery,” Steves said.
While Micron’s report was “far from squeaky clean,” BMO Capital Markets analyst Ambrish Srivastava said investors should be patient and buy the stock on the weakness ahead of an “eventual recovery.”
Micron emerged from its report as a “structurally more profitable company,” and the case for upside in the stock remains unchanged, the analyst said.
DRAM, NAND Outlook
DRAM cost reductions in fiscal 2020 will be a high single-digit, which is less than what was seen in 2019, Mizuho Securities analyst Vijay Rakesh said in a note.
The company has limited opportunities for NAND cost reductions as it moves to a replacement gate, the analyst said.
Nevertheless, the company’s performance in 2020 “should look better” due to catalysts across the 5G and data center markets, he said.
Micron’s fiscal first-quarter guidance for a 400-basis point decline in gross margins to 26.5% is disappointing, Wedbush analyst Matt Bryson said in a note.
The outlook comes at a time when the company’s commentary is focused on improving fundamentals, the analyst said.
Near-term concerns remain unchanged, including softening handset trends and PC builds in the late fourth quarter through the first quarter time frame, he said.
Yet the memory market is likely one or two quarters away from bottoming, which gives investors reason to believe that increasing earnings will be seen afterwards, Bryson said.
The likelihood of a gross margin recovery in fiscal 2020 remains questionable due to limited DRAM cost improvements, while NAND cost declines won’t be notable until Micron fully ramps the new replacement gate technology in fiscal 2021, KeyBanc Capital Markets Weston Twigg said in a note.
The company also highlighted underutilization related to IMFT and a change in the depreciation schedule for NAND equipment, the analyst said.
It will be “hard to predict” if gross margins will move higher in the near-term, although they should move higher from 29% in fiscal 2020 to 38% in fiscal 2021, he said.”
This news comes as the stock appears to have failed to break through resistance and a new down move is now likely.
A Trade for Short Term Bulls
As with the ownership of any stock, buying MU could require a significant amount of capital and exposes the investor to standard risks of owning a stock.
To reduce the risks of a trade, an investor could purchase a call option. This allows them to benefit from upside moves in the stock while limiting risk to the amount paid for the options. However, buying a call option can also require a significant amount of capital and includes the risk of a 100% loss.
Whenever an option is bought, the maximum risk is always equal to 100% of the amount of spent to purchase the option. Since options cost significantly less than a stock, the risk in dollar terms will usually be relatively small to own an option.
To further limit the risks of the trade, an investor could use a bull call spread. This strategy consists of buying one call option and selling another at a higher strike price to help pay for the cost of buying the first call. The spread strategy always reduces the risk of an options trade.
This strategy is designed to profit from a gain in the underlying stock’s price but has the benefit of avoiding the large up-front capital outlay and downside risk of outright stock ownership. The potential risks and rewards of this strategy are summarized in the chart below.
Source: The Options Industry Council
Both the potential profit and loss for the bull call spread are limited. The maximum loss is equal to the net premium paid when the trade is opened. The maximum profit is limited to the difference between the strike prices, less the debit paid to put on the position.
This strategy could be especially appealing with high priced stocks where the share price and options premiums are often a significant commitment of capital for smaller investors.
A Specific Trade for MU
Every day, we scan the markets looking for trades with low risk and high potential rewards. These trades are available almost every day and we share them with you as we find them. Now, it’s important to remember these are trading opportunities in volatile stocks.
When we find a potential opportunity, we evaluate it with real market data. But because the trades are volatile, the opportunities may differ by the time you read this. To help you evaluate the current opportunity, we show our math and explain the strategy.
For MU, the November 15 options allow a trader to gain exposure to the stock.
A November 15 $43 call option can be bought for about $5.15 and the November 15 $46 call could be sold for about $4.22. This trade would cost $0.93 to open, or $93 since each contract covers 100 shares of stock.
The amount paid to enter the trade is the largest possible loss on the trade. This is generally true whenever a trader is creating a debit to enter an options trade. “Creating a debit” means there is a cost to enter the trade. You could create a debit by simply buying puts or calls to open a directional trade.
In this trade, the maximum loss would be equal to the amount spent to open the trade, or $93.
The maximum gain on the trade is equal to the difference in exercise prices less the amount of the premium paid to open the trade.
For this trade in MU the maximum gain is $2.07 ($46 – $43= $3; $3 – $0.93 = $2.07). This represents $207 per contract since each contract covers 100 shares.
Most brokers will require minimum trading capital equal to the risk on the trade, or $93 to open this trade.
That is a potential gain of about 122% based on the amount risked in the trade. The trade could be closed early if the maximum gain is realized before the options expire.