Thursday, September 20, 2012

Breakout Stock Could Make You 38% Before Hitting Resistance: AU

Quantitative easing has historically been good for stocks, bonds and gold. And given that the Federal Reserve's latest QE program is open-ended, we might see the benefits of easy monetary policy in the markets for some time.

While buying when the Fed eases has been profitable in the past, it still pays to be selective and try to buy stocks that have value, earnings growth and a chart pattern that supports higher prices. The hunt for that kind of stock led me to the gold miners where a large-cap bargain is trading at a reasonable valuation, has excellent long-term earnings prospects, and a chart that points to much higher prices.

Gold is a volatile market to trade, and the price of the metal looks like it has reached a critical level. It could break out to new all-time highs, but first it needs to close above significant resistance levels. There are ways to trade prices that are at inflection points, but there are also safer ways to trade the gold market.

Mining stocks are a leveraged bet on gold prices that can offer gains greater than the metal would in a bull market, and undervalued mining stocks could deliver gains even in a gold bear market. That makes a trade in this mining stock low risk since it could provide gains no matter what gold does.

Miners are called leveraged metal trades because their cost of production is relatively fixed, so increased market prices can lead directly to greater profits. This company reported a cost of production of $801 an ounce and expects to continue mining more than 4 million ounces a year at a cost of $780 to $805 an ounce over the next year. Gold trades for more than $1,700 an ounce, and even the most bearish forecasts call for prices of more than $1,100 an ounce. At $800 an ounce, profitability is virtually guaranteed.

That could explain why fundamental analysts are excited about AngloGold Ashanti (NYSE: AU). Their average one-year price target for the stock is $53.02, about 46% above the recent price. At the target price, AU would be trading at a price-to-earnings (P/E) ratio of about 12 based on next year's estimated earnings, a reasonable valuation for any company. And that price is also near targets derived from technical analysis.

AU Chart

AU appears to have formed a triple-bottom and looks like it is ready to move higher now. Resistance at $50 looks like it could be significant, but that leaves room for a potential gain of almost 40%. Risk can be managed with a stop at $34.45 where AU would fall back into the trading range that preceded the breakout. Falling back to that price would indicate that the breakout has failed.

Although AU can make money mining gold at a cost of about $800 an ounce, the industry leaders are able to pull gold out of their mines for less than $350 an ounce. Cost cutting, which certainly seems possible for this company, could lead to even bigger profits at AU. Potential savings could be the reason that analysts are expecting annual earnings growth to average 65% a year for the next five years.

The stock is currently priced at about 9.3 times earnings over the past 12 months, a P/E ratio that is below average for this stock market. The company has been spending aggressively on new mines and increased capacity. Analysts underestimated the impact this spending would have on earnings, and the company has missed their earnings estimates twice in the past four quarters. However, that spending is expected to result in increased production later this year, and lower capital spending should help AU deliver steadier earnings.

With steady earnings, AU could become a favorite among value investors and deliver gains to traders buying now.

Recommended Trade Setup:

-- Buy AU at the market price
-- Set stop-loss at $34.45
-- Set initial price target at $50 for a potential 38% gain in 6-12 months

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