Keep An Eye On Ecopetrol For A Shorting Opportunity

Sep.25.12 | About: Ecopetrol S.A. (EC)

Ecopetrol (NYSE:EC) has strongly outperformed this year by increasing 32% since January. This run up in share price represents an addition of over $30 billion in shareholder value over the past 8 months. Through this article, I present the argument that Ecopetrol has increased due to price speculation and the current fundamental landscape is potentially troubling.

Organizational Returns

In order to evaluate Ecopetrol, I have relied on two key ratios: return on assets and return on equity. Return on assets is net income divided by assets. Return on assets is useful in that it shows how efficiently the firm utilizes assets to generate profits. Return on equity is similar in that it is net income divided by directly-invested shareholder equity. Return on equity allows investors to analyze profits in relation to investments.

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The chart above shows 5 years of return on asset and return on equity data. To put the return on assets and return on equity into perspective, I have included the market value of the firm to show how returns have historically driven shareholder value. The firm began reporting consistent returns in 2010. These returns were healthy and over the next 2 years, they continued to grow. The market responded to the increase in firm asset-efficiency and investment-effectiveness by increasing the stock price by over 200%. The correlation between return on assets, return on equity, and market value can clearly be seen between 2010 and 2012. This strong relationship makes sense: as the firm increases its ability to cultivate profits from assets and investments, the market responds by purchasing the stock and driving up shareholder value. In 2012, however, the picture began to reverse. For the past two quarters, returns have decreased on a quarter-to-quarter basis. This reversal represents a decrease in the ability of Ecopetrol to reap profits through its traditional utilization of assets and equity. Despite this clear reversal in fundamental performance, share price has failed to decrease.

The decoupling between firm performance and market performance represent a developing investment opportunity. As the firm has gradually decreased its ability to translate assets into profits, the market price has rallied. This recent rally in prices allows a nimble investor the opportunity to short in the face of a developing erosion of fundamental performance. Ecopetrol is currently in the beginning stages of a process which could lead to a decrease in firm profitability as it struggles to generate strong returns in the future.

It is important to note that investors who believe that Ecopetrol could potentially be declining should be aware that they are preempting many of the traditional fundamental metrics that analysts rely on. For example, this decrease in firm performance has not yet transcribed into a decrease in firm profitability, as seen in the chart below.

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The chart above clearly shows that while profitability has decreased over the past two quarters, the magnitude of said decrease is not in line with the degradation of organizational returns. I personally believe that the recent decrease in returns will translate into a decrease in firm profitability, however, as things stand, Ecopetrol is still a solid company which is giving preemptive signs of a decline in fundamental performance.

In order to best time an entry into Ecopetrol, I recommend utilizing technical analysis. As the chart below clearly denotes, EC is in a solid uptrend. For this reason, I believe that investors should wait until prices decline below $50 per share prior to entering any short trade. For investors who are long the security, I believe that this represents an excellent exiting opportunity since any decrease below this price will technically signal the end of the trend.

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The fundamental thesis of this article is that Ecopetrol has potentially reached a top due to a decrease in return on assets and return on equity. Since these returns are now decreasing, Ecopetrol may find it more difficult to defend its competitive edge. If the firm is unable to reverse its fundamental decline, then inevitably profitability will suffer. It is important to note that profitability has not substantially declined and Ecopetrol is still in an acceptable fundamental condition. The recent decrease in return does warn of potential decrease in profitability over the next few quarters. Nimble investors should position themselves to profit should the slowdown in firm returns lead to a decline in share price.

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.