Tim Bovee, Private Trader: MERC: A bullish speculation

Update 2/9/2015: I've closed my position in MERC and calculated results.

The shares rose by +22.7% over the 253-day lifespan of the position, for a +33% annual rate.

There were no hedges.

Update 6/1/2014: I've opened a bull positioned in MERC, structured as long shares.

Mercer International Inc. (MERC) is a speculative play, with a bullish chart, positive analyst sentiment and financials that are the picture of a company emerging, like the Phoenix, from the ashes.

Its break above the 20-day price channel on Monday has been followed by a powerful push to the upside, suggesting that the analysts may be right. But the chart shows the Phoenix may have its talon caught in the rubble.

The Chart

MERC's rise of the past few days has pushed past the wave 3 {+3} high of Nov. 12, 2013, suggesting two possible conclusions under Elliott wave analysis.

Click on chart to enlarge.

MERC 2 years 3 months daily bars (left), 13 days hourly bars (right)

The bullish scenario, which I've used as my primary count, concludes that the higher high means that MERC began its wave 5 {+3} leg up in March.

The bearish scenario, my alternate count, concludes that wave 4 {+3} is still underway and is tracing out a flat.

The truth of the chart will be known when MERC either continues on to new heights, breaking above the $15.27 peak of wave 1 {+4} in April 2011 (the bullish case), or reverses and falls below the $10.55 wave 3 {+3} peak of October 2013.

The case for the alternate count is strengthened by the fact that wave 2 {+3} was a zig-zag, and 4th waves often alternate in from with the 2nds, suggesting a flat is likely.

Duration, however, is on the side of the primary count. Wave 2 {+3} lasted six months plus change, and wave 4 {+3} under this scenario lasted four months plus a few weeks.

That's a long way of saying that there is no way to choose between the two scenarios at this point. The chart must work out its form in the fullness of time.

Odds and Yields

MERC has completed two bull signals since wave 3 {+3} began in May 2013. Both were successful, on average yielding 24.5% over 94 days.

One of the breakouts occurred during wave 5 {+3}, the present leg up that began in March. It yielded 10.1% over 16 days.

The Company

Mercer International, headquartered in Vancouver, British Columbia, is the second largest producer globally of northern beached softwood kraft, or NBSK, a pulp from lumber used in manufacturing kraft paper, from which a variety of containers are made. It is also used as insulation and the base for sandpaper.

The company serves markets in North America, Europe and Asia from three pulp mills, one in British Columbia and two in Germany. It has branched out into power production by converting a portion of the wood that passes through its mills into a biofuel called black liquor.

Mercer reports a 2% loss on equity with debt amounting to 250 times equity.

The company reported its first profitable quarter this year since 2012, after suffering a string of six straight losers. It has surprised to the upside only twice in the past three years, most recently this year and before that back in 2012.

In the face of those dismal numbers, Mercer is a rising star among analysts, with a bullish rating from Zacks Investment Research, which published a positive brief today, and much bullish activity by insiders.

The markets are future-looking, reflecting hopes and fears about things to come. In that respect, Mercer's future is seen as bright.

That bright future has yet to show up in the price, however. Mercer's growth estimates imply a "fair" price of $73.13 per share, and the stock is selling for only 15% of that amount. The stock is also selling at a discount to sales. It takes 60 cents in shares to control a dollar in sales.

I tend to be a bit cynical about cheap stocks. They're usually cheap for a reason. In Mercer's case, the discrepancy between the price and the estimates is huge, and I don't know why.

The profile that I'm seeing is of a very speculative play. That's not disqualifying. I have room in my portfolio for speculation. Risk is the mother of profit. With MERC, dear old Mom is showing her demanding side, as mothers are sometimes wont to do.

Options are pricing in confidence that 68.2% of trades will fall between $9.78 and $12 over the next month, for a potential gain or loss of 10.2%, and between $7.05 and $14.73 over the next year, for a potential 35.3% gain or loss. I've marked the one-month range on the left-hand chart in blue.

Institutions own 60% of shares.

Mercer next publishes earnings on July 31. The stock pays no dividend.

Liquidity and Volatility

MERC on average trades 164,000 shares per day. It has a small selection of option strike prices with open interest running from the low three figures downward.

The front-month at-the-money bid/ask spread on calls is 44%, compared to 0.3% on the most-traded symbol on the U.S. markets, the exchange-traded fund SPY.

The options aren't liquid enough for me to trade. Any position will be structured as long shares.

Implied volatility stands at 35%, compared to 11% for the S&P 500 index. MERC's volatility stands at the 39th percentile of its one-year range, suggesting that long shares are an appropriate trading vehicle.

Contracts today are heavily skewed toward puts, which are running at nearly three times their five-day average volume. Calls are running 9% below average.

Decision for My Account

"Speculation, speculation," says Caroline Hamelin in Émile Zola's 1890 novel Money. "Ah! the idea of it fills my heart with disturbing anguish."

And so it is with MERC. This is a very speculative play. The company has only one winning quarter out of the last seven, and the product is wood pulp, hardly the stuff of Jobsian innovation.

Yet, the chart is bullish, with the usual reservations that are quite common in Elliott wave analysis. And the pricing and estimates are sweet.

Ultimately, a play on MERC is a bet on those estimates, especially the bullish rating from Zacks.

Buttressed by the chart, and also the momentum shown by the odds of bull-signal profit, it is a bet I'm willing to take.

I intend to open a bull position in MERC under my longer-term trading rules. I'll place the trade today if I'm satisfied with the upward momentum; otherwise, I'll put the symbol on my Watchlist.

-- Tim Bovee, Portland, Oregon, July 1, 2014

References

My shorter-term trading rules can be read here. My longer-term trading rules can be read here. And the classic Turtle Trading rules on which my rules are based can be read here.

I use the number 68.2% in using applied volatility to calculate the expected trading range. This comes from statistics and refers to the one standard deviation boundaries, which are expected to contain 68.2% of whatever is being studied. Putting it another way, given an item (a trade or whatever), there is a 68.2% chance that it will appear within those boundaries.

Elliott wave analysis tracks patterns in price movements. The principal practitioner of Elliott wave analysis is Robert Prechter at Elliott Wave International. His book, Elliott Wave Principle, is a must-read for people interested in this form of analysis, as is his most recent publication, Visual Guide to Elliott Wave Trading.

Several web sites summarize Elliott wave theory, among them, Investopedia, StockCharts and Wikipedia.

See my post "Chart Analysis: Nomenclature" for an explanation of my method for labeling waves on the chart.

By preference I place my shorter-term trades in the last half hour before the closing bell in New York. See my essay "When is the best time to trade" for a discussion of the practice.

Disclaimer

Tim Bovee, Private Trader tracks the analysis and trades of a private trader for his own accounts. Nothing in this blog constitutes a recommendation to buy or sell stocks, options or any other financial instrument. The only purpose of this blog is to provide education and entertainment.

No trader is ever 100 percent successful in his or her trades. Trading in the stock and option markets is risky and uncertain. Each trader must make trading decisions for his or her own account, and take responsibility for the consequences.