Email – #483

** China’s National Bird and Ketchup

When traveling across China, as I have done many times over the past few years, the most observable sign of growth is the number of cranes. Not the birds, but the heavy construction cranes that dot the landscape. A friend who recently returned confirmed that there is no lack of new building going on in China.
 
The construction sector has been hard hit in most of the world, more so in the US than any other country. But, that might be about to change. With the current dollars allocated to infrastructure, there is a good probability that the construction equipment sector may experience a rally that will dwarf all other sectors.

Those that jumped into this sector last November when plans of a multi-hundred billion dollar spending spree in the US and China was announced, have been flattened by getting in too early. As is often the case in investing, being early does not always equate to making money. Sometimes you can be too early.

Now, we have evidence of a pickup in economic activity, a modest one to be sure, but activity has to start somewhere. We may not be in for a residential boom, but we are surely heading into a construction boom when it comes to non-residential and non-commercial construction. There are many ways to play this possibility. The most obvious is through companies like Caterpillar or Fluor. But the options on these companies are too expensive.

What I am looking for is a complementary investment – one that will move on the backs of movement in this sector because it will benefit as well. Back in Economics 101 we learned that when hamburger consumption increases, so does demand for ketchup.

We want to buy the ketchup.

Please Pass The Profits
 
For us, as LEAPS investors we also need to be in a situation that is volatile. Since LEAPS do eventually expire, we don’t like static situations. Furthermore, in this treacherous market, we need to increase our odds of winning by adopting a different strategy every once in a while.

We adopt this strategy – called a strangle – when we are not completely sure of the direction of a stock, but we know that when it does move, it will move sharply in one particular direction. By doing so, the profits from the move in one direction should offset the losses of the move in the opposite direction… or at worst mitigate some of the losses from the overall investment.

I’ll explain in detail how a strangle works in a moment…
 
The company I am looking at is called Manitowoc (MTW-NYSE). It is a manufacturer of cranes and foodservice equipment (like refrigeration equipment, ice machines etc.) The bulk of its revenues and profits come from the heavy building equipment, although the revenues and profits from food service is nothing to sneeze at either.
 
Over the past year the company has seen a slowdown in business that put MTW on the brink. Although it was still profitable, it began to see business slowing down to a point where it would be forced to divest businesses and renegotiate bank lines. It was during this period when the early investors got slammed.

Since then, the company has divested and restructured its finances. The question that remains is whether global economies recover fast enough and whether this company will be in a position to benefit when this happens. A year ago, the shares were trading over $40. Today they are trading below $6.

We’ll make two bets on MTW, a call bet and a put bet.
 
Strangle: The Definition and How We’re Going To Use It

Our strategy is called a STRANGLE. In a strangle, we buy a put option (a bet that the shares are going lower) and a CALL option (A bet that the shares are going higher). We buy put and call options that are out of the money, meaning not at or near the underlying price.

For example, if the shares were at 10, we would buy the 7.50 puts and the 12.50 calls. If we bought the $10 puts and the $10 calls, it would be called a STRADDLE.
 
Ok, so here is the play:

* Buy the Manitowoc January 2011 $2.50 PUT options (VMT MZ), currently trading at $0.70. Do not pay more than $0.75.
* On the call side, buy the Manitowoc January 2011 $7.50 CALL options (VMT AU), currently trading at $1.90. Do not pay more than $2.05.

Our bias on this trade is bullish. We are buying the $2.50 puts to protect some downside. We don’t want the shares to go there, because that would probably mean that MTW is going under, in which case we would recoup most of our outlay for the puts and the calls. What we would rather see happen is a pickup in global infrastructure and heavy construction activity – a move that would send the shares soaring into the teens overnight.
 
Again, do not pay more than $0.75 for the puts and $2.05 for the calls, for a total outlay not to exceed $2.80 per contract. 

Karim