Try These Overlooked Low-Risk, High-Reward Trades

by: Marc Courtenay

"The best time to plant a tree is 20 years ago; The second best time is today!"--Ancient Chinese Proverb

Everyone wants to buy yesterday's winners, but it's much more challenging to find tomorrow's "champions".

Today we're focusing our attention on companies where the risk is either relatively low or "washed out" as a result of some recent announcement that crushed the share price. The stocks mentioned here will be potential "resource champions" whose operations are focused on products that the world wants now and will want even more of later.

Let's Start Where Food Begins

How would you like to own shares of a company that offers solid and liquid phosphate fertilizers; animal feed supplements; and industrial acids that are used in food products and industrial processes?

In addition, this company produces nitrogen fertilizers, as well as nitrogen feed and industrial products, including ammonia, urea, nitrogen solutions, ammonium nitrate, and nitric acid.

If that isn't enough, it holds the right to mine 785,759 acres of land in Saskatchewan; and 58,263 acres of land in New Brunswick in Canada.

This almost 59-year old company sells its fertilizers primarily to retailers, dealers, co-operatives, distributors, and many other fertilizer producers. It markets its industrial products primarily to chemical product manufacturers; and purified phosphoric acid directly to consumers of this essential product of the food-growing chain.

If you haven't guessed yet, I'm speaking about Potash Corp. of Saskatchewan (NYSE:POT), the world's largest producer of the three primary plant nutrients: potash, phosphate and nitrogen. The worldwide demand for these is staggering. Potash has a market cap of over $37 billion and is selling at 13X current earnings and 10.5 times forward earnings.

Over the past 3 years its average return-on-equity has been over 29% and its trailing-twelve-month (NYSE:TTM) return-on-equity (ROE) was an impressive 38.35%. As you may know, ROE reveals how much profit a company generates with the money shareholders have invested. In comparison, its competitor The Mosaic Company (NYSE:MOS) had an ROE of less than 22%.

With Operating Cash Flow of $3.22 billion, we get to buy POT for less than 12 times cash flow, and that's a good part of the value theme here. At around $43.50 we'd be buying POT for less than 11 times cash flow. About a year ago it was selling for over 15 times cash flow.

As you can see from the one-year chart POT recently moved above its 50-day moving average and well off it's 52-week low of $38.42 last month. If we buy the shares at $43.60, and we choose our "mental" stop loss point just below the 52-week low of $38.42, we are taking about a 12% risk. On the other hand, if POT moves back towards its 2011 highs (let's say around $60.60), we'd be set up for a potential 39% gain. That's the kind of risk-reward ratio that most traders and investors are comfortable with, but you'll have to decide if that works for you.

The Next 3 Companies "Shine" for Similar Reasons

Let's begin with a company that broke investors' hearts on January 11th when it announced that one of its most important mines would be shut down. Then the crushing blow included a 2012 production estimate reduction of over 26%.

By now you may have guessed I'm speaking about Hecla Mining (NYSE:HL) whose symbol on the day of that announcement may have signified a "hell" of a disappointment. But if you're luckier than those of us who already owned it when the stock plunged more than 20%, you'll get to buy this very profitable silver producing company at a sharp discount.

The company's announcement doesn't mean they're not going to make solid profits in 2012. Hecla's 2012 silver production is now estimated to be approximately 7 million ounces.

As a result of the bad news, the stock price of HL hit a 52-week low on January 11th of $4.25. Today (January 12th) it rebounded to around $4.80 on almost double the average daily volume. Hecla is selling at a price-to-book ratio of around 1.2, has very little debt, and is currently sitting on around $1.48 of cash-per-share (for a total of almost $414 million). Traders and investors may want to see if the share price tests the January 11th low before buying, or just keep an eye and gradually buy-in as more details are available.

If the follow-through company announcements are discouraging, it might have an estimated 15% downside if one bought the shares at $4.50. I base this on the price support on January 11th and share-price history going back to January 13, 2010. On the other hand, if the future announcements are encouraging, it wouldn't surprise me to see HL move towards its 200-day Moving Average (currently around $7.19).

For those who would have a buy-in price of $4.50, if the stock moved to $7 that would be a 55% upside. Again a risk-reward ratio that makes sense, especially if we use a "mental" stop loss of around $4, would equal an approximate 10% downside risk.

The last two "overlooked, low-risk, high-reward" trades involve the precious metals sector beginning with gold. Gold prices tend to "shine" during the first four months of the year, as the 5-year chart of the SPDR Gold ETF (NYSEARCA:GLD) clearly demonstrates.

Here's that same 5-year chart comparing GLD with the company that has a lot more upside potential than downside risk.

I'm speaking about IAMGOLD Corp. (NYSE:IAG), which engages in the exploration, development, and production of mineral resource properties worldwide. It primarily explores for gold, silver, zinc, copper, niobium, diamonds, and other metals. The company holds interests in eight operating gold mines, a niobium producer, a diamond royalty, and exploration and development projects located in Africa and the Americas.

Its advanced exploration and development projects include the Westwood project in Canada; and the Quimsacocha project, which consists of 3 mining concessions covering an aggregate area of approximately 8,030 hectares in Ecuador.

It's Key Financial Statistics speak to why it is one of the four "trades" worthy of our consideration. Among other statistics its ROE is a respectable 15.33% and its profit margin an even better 48% .

The "profit margin" is an important measure of profitability, and if the price of gold stays where it's currently at or moves higher during these times of international tensions and uncertainty, IAG looks poised to increase both its profit margin and their operating margin.

There's no reason not to think that the current operating margin of 36% might actually increase in a world where gold prices and demand are growing. Take a look at the recent "Markets at a Glance" put out by Eric Sprott's "Sprott Asset Management" and you'll see what I mean.

IAG has over $1 billion in total cash and zero debt. They could make some very accretive acquisitions or be acquired themselves. If purchased at around $17-a-share, the downside risk (considering a "mental" stop loss at their 52-week low of $14.69) would be approximately 13.5%.

Their upside potential is, in my opinion and in the opinion of other independent analysts, slightly above their 52-week high of nearly $24. That would be a 41% increase if you bought in at $17.

And I might say that this upside potential is relatively conservative considering how it stacks up against it's peers such as Yamana Gold (NYSE:AUY), which had a nice "pop" after announcing their operating results and 2012-2014 outlook, and Kinross Gold (NYSE:KGC), which has $1.88 billion in cash but $1.44 billion in debt.

My final overlooked trade is a toss-up between Vale S.A. (NYSE:VALE) and First Majestic Silver (NYSE:AG).

Vale is the very profitable company renowned for its exploration, production, and sale of basic metals in Brazil and another metals producer. Vale bounced off its 12-month low of $20.46 back in December 2011, and as of the close on January 12th stands at only $23.29. That means its selling for less than 6 times current and projected earnings.

If it moved back up to its 2011 highs of over $32-a-share from the current price we'd experience nearly a 39% return on our investment. If we use a mental stop loss of $20.29 (slightly below it's Dec.2011 low) the downside risk would be around 13%. Again, a worthwhile ratio!

The other "toss-up" company, First Majestic Silver, engages in the production, development, exploration, and acquisition of mineral properties with a focus on silver in Mexico.

It has a very nice balance sheet with virtually no debt and its current total assets from 12/31/09 to 12/31/10 have more than tripled. At its current share price (around $18.66) its selling for a little more than 10 times forward earnings and their quarterly earnings growth (year-over-year) was up an amazing 176%.

My "caveat" here is that if it had a major problem like Hecla did, and its share price fell to the 52-week low of around $10.32 (on Jan.25, 2011) and we bought at the current price of $18.66, we'd experience an unacceptable 45% loss.

That's why I may wait to buy on a pull-back to near it's current 50-day Moving Average (around $16.70) before establishing a position. This way, if AG moved up to it's 52-week high of around $25.70 (April 5, 2011) we'd have a potential gain of 54%. I'd want to again use a pre-determined "mental" stop loss to control my downside risk.

There are a number of other overlooked, relatively low-risk/high-reward companies out there right now and I'll be watching them and others to evaluate their potential and their risk factors.

Remember, analyze each company carefully, visit their web sites, read their announcements and news stories, and limit your exposure to your own risk tolerance levels.

As HL proved yesterday, these kind of companies can plunge dramatically faster and more suddenly then they are likely to soar. That's why I'll keep encouraging you from now on to consider "mental" stop losses or hedges (like option put contracts) to limit your downside risk.

Disclosure: I am long POT, MOS, GLD, HL, VALE, IAG, KGC.