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Steer Clear of Alcoa Stock (AA)

When it rains, it pours.

Steer Clear of Alcoa Stock (AA)Nomura downgraded aluminum leader Alcoa (AA) to “neutral” from “buy.” But this is a case of closing the barn door after the horse has already bolted. Alcoa stock is down by more than half in the past 12 months, and there is no sign of a bottom.

With demand for its products being highly cyclical, Alcoa stock is typically pretty volatile. Its shares can double in a year … and then give back all the gains and more the following year.

So with Alcoa stock so badly battered, might now be a decent time to bet on a cyclical recovery?

Let’s take a look.

Both Sides of The AA Stock Coin

We’ll start with the potentially good news. Alcoa announced in September that it planned to split into two companies, one an “upstream” company focused on production and the other a “midstream” and “downstream” company focused on finished aluminum products.

Judging by the performance of AA stock, investors weren’t too impressed. But might there be value here?

The upstream company will be a producer of commodity products. There’s not much to get excited about there. But the finished-products company might be a different story. Should the boom continue in commercial aviation and auto making, this new spin-off would be in the right place at the right time.

Already, aerospace accounts for about 40% of finished-product revenues.

Now for the bad news. The rump commodity producer Alcoa will be even more risky and speculative than the combined company is today. It will be entirely at the mercy of the aluminum price. And this, in turn, is almost entirely at the mercy of Chinese growth.

China gobbles up about half of all global aluminum production. So a major hard landing in China would mean a total collapse in the price of aluminum.

Aluminum prices have been rising in November, but they remain in a major, multiyear downtrend and prices today are only marginally higher than the 2009 lows. And with China’s go-go years of growth behind it, there is no reason to expect a reversal any time soon.

But even with a gloomy macro backdrop, there is a price at which any stock becomes interesting, right? Let’s take a look at the cyclically adjusted price-to-earnings ratio and price-to-sales ratio of Alcoa stock for a little perspective.

chartchart (1)

In looking at the Shiller P/E ratio, which uses a ten-year average of earnings, Alcoa stock actually looks modestly expensive, even after losing more than half its value over the past year.

Using the price/sales ratio, Alcoa looks a little more reasonably priced, though certainly not an obvious bargain. Today’s valuation is about in line with the average of the past seven years.

Bottom Line

So, what is an investor to do?

For now, steer clear of AA stock.

The macro backdrop remains terrible, and the stock isn’t quite cheap enough to warrant rolling the dice. Furthermore, there is absolutely no point in buying Alcoa stock before the split happens next year.

Once the dust settles, the midstream/downstream spinoff might be a decent buy if the price is right. But the rump commodity Alcoa will almost certainly drift lower unless the price of aluminum makes a major recovery in the next six months.

Whatever gains you’d get from the spinoff would likely be lost with the rump.

So, if you’re just dying to buy Alcoa, be patient. Post-split, there might be some real value to be found.

But for now, the risks outweigh any potential for reward.

Charles Lewis Sizemore, CFA, is the chief investment officer of investment firm Sizemore Capital Management. Click here to receive his FREE weekly e-letter covering top market insights, trends, and the best stocks and ETFs to profit from today’s best global value plays. As of this writing, he did not hold positions in any of the aforementioned stocks.

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