Short Duke Energy And The Bursting Of A Speculative Trend

Sep.13.13 | About: Duke Energy (DUK)

Duke Energy (NYSE:DUK) has experienced a roller coaster ride this year. At one point, shares were up over 16% however during the middle of the year, price began a decline which currently leaves shareholders sitting on an unrealized gain of 1.6% for the year. In this article, I will explore the past 5 years of economic data for Duke Energy as well as 30 years of stock prices and arrive at the conclusion that shareholders can expect further downside.

A Varied Approach

Unlike traditional research articles which focus exclusively on one or two economic variables, I will examine several unrelated inputs. It is my belief that through the study of multiple forms of analysis, we can arrive at a more holistic investment decision.

Fundamentally Speaking

In order to objectively analyze Duke from a fundamental standpoint, I have relied heavily on return on assets. Return on assets is the net income of a company divided by the average total assets across an operating cycle. Duke is a major energy company with over 58 gigawatts of base-load and peak generation capacity. This essentially means that the assets that Duke owns are enough to power a large percentage of the various independent system operators' load in which it competes. For our purposes, as we study Duke's return on assets, we are studying how effectively it is able to capture the market "heat rate" or thermal conversion of energy from one form to another. In other words, how well can Duke produce power while controlling its feedstock cost. The chart below shows 5 years of return on assets for Duke Energy.

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In the chart above, three distinct economic time periods can be seen. In the points below, I have discussed these cycles.

  1. Our analysis begins with the fourth quarter of 2008 until the second quarter of 2009. During this time period, Duke experienced a decrease in performance in that its return on assets declined substantially. This tangibly means that over these months, Duke delivered less revenue per unit of expense. In other words, Duke was both unable to secure low-priced feedstocks, such as natural gas and coal and the market prices were not favorable in the regions in which Duke was dispatched. During this time period, Duke would have been better off unraveling hedges on energy commodities, which fell substantially over these months. The market does not favor companies which experience declining returns as witnessed by a slump in shares of over 13%.
  2. The next significant economic period is from the third quarter of 2010 until the second quarter of 2011. This period of time was marked by a surge in performance within Duke Energy. The reasons for this surge are multi-faceted. For one, overall economic demand, which is the largest driver of the energy sector, surged. Another reason for this growth is that major feedstocks such as natural gas were at historic lows and declining, allowing Duke to lower its breakeven production price. What is important for our analysis however, is that over this time period, returns surged and the market responded by adding over 13% to the share price.
  3. The final period of our analysis is from the third quarter of 2011 until the present. Over this time period, returns have consistently declined in every quarter except one. This is very significant in that it shows that Duke has been unable to consistently control expenses and capture market pricing. What this tangibly means for shareholders is that future price declines are more than likely in store.

The table below shows a summary of this discussion.

In the table above, a simple economic relationship is at work. As a firm betters itself fundamentally, its stock price tends to rise. Conversely, as a firm fundamentally declines, its shares tend to fall. This relationship is intuitive and indicative of future price direction. It is my belief that the volatile ride experienced in Duke this year has been representative of the fact that the market was caught in a speculative mania in which it attempted to predict future profits and failed. The major reversal in the middle of the year represents capitulation in which speculative investors were caught in their own gamble. It is my belief that the preponderance of fundamental analysis, as measured by the comprehensive figure return on assets suggests that the price decline which started in the middle of the year is scheduled to resume. For this reason, I advocate shorting Duke or selling out of an existing position.

A Multi-Faceted Approach to Investment

As I mentioned earlier, I prefer to not rely on a single input when approaching an investment. Through examining multiple unrelated fields, I have found that I can best position myself to understand the potential future direction of price.

Statistically Speaking

In order to further examine Duke Energy, I have applied statistical studies to the price history of the organization. Specifically, I have examined where Duke Energy falls within its 50-week trading range and found all such similar price environments. What I have found using this approach of analysis is very telling of future price direction. The table below shows a distribution of what has historically occurred to Duke's market price over the next two years following similar market action.

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In 68% of all similar periods, Duke has experienced a price decline over the next two years. Statistically, this means that given the current environment, Duke will more than likely decline in the future. This is significant in that it means that statistics suggests that our fundamental thesis of further price decline is entirely possible and probable.

Pattern Recognition

Another investment technique which I utilize in my personal portfolio is that of pattern recognition. Using technology which is used to recognize recurring patterns in data, I have sought out every single market environment which is similar to that of this year. The significance of this study is that it allows us to determine if the market is providing any clues as to where price may travel in the future. The table below is a distribution of market returns over the next month following market environments similar to that of today.

What I find noteworthy is not necessarily the shape of the distribution, which is clearly bearish, but that in 64% of all similar periods, price has declined over the next month. Even though this analysis is unrelated to our fundamental thesis, it provides additional insight that price may decline in the future.

Conclusion

By using a multi-faceted approach to investment, we can better our odds of making money on any given idea. In this article, I have established the fundamental thesis that returns are declining and share price will more than likely continue to follow. Additionally, I have provided two unrelated yet statistically valid methods which each suggest that future declines are probable. In light of the given evidence, the only logical thing that remains is to short Duke Energy, sell shares, or hedge existing positions.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.