Covering My XTO Short

There are many reasons to enter into a trade. Whether the impetus is a belief about long-term value or focuses on short-term price movements, people arrive at investment decisions in different manners. Seeing no need to delve into the merits of each investor's decision-making process, I will highlight one factor all should share. When you make a decision, it is extremely important to understand what dictated the choice so you can identify reasons for changing your view.

As data has become more available and trading costs have dropped, investors face a constant stream of new information that must be processed in rapid fashion. Given the constant flow, it is easy to become overwhelmed and not know how to respond. However, if our initial thought process was built upon a few key factors, we can eliminate the noise, focus on what truly matters, and respond properly.

Last week in EPIC Insights, I recommended selling short XTO Energy (XTO). At the time, XTO was selling 2% above my estimate of long-term reserve value whereas the stock had traditionally sold at a 13%-20% discount. On a short-term basis, XTO had shown a 0.6 correlation to the price of oil, but had declined only 0.5% at a time when oil dropped 9%. Anchoring on these factors, I was able to watch for short-term price swings and the relative value of reserves versus the stock price to determine whether my short position was justified.

During a volatile, chaotic week, much has changed. Given the rally in energy prices and the sell-off in XTO, we now see a stock that is 23% undervalued versus its reserve value (Figure 5). This is in line with the long-term average and makes further weakness unlikely. In addition, since September 16 oil has declined 3.4% with XTO falling 4.8%. Together, what had once been an overvalued, overbought stock that required being short of is now a fairly valued oversold stock which we should no longer be short of.

Having correctly called for shorting XTO, we earned a one-week profit of 7%. However, now that the facts have changed, our position must as well. When entering new trades, the focus should always be on price as opposed to time. Some ideas will take months to work; others will take days. With a profit in hand and the market moving, we must head to the sidelines. I recommend closing the short position in XTO as this week's fundamental trade.