Katz: Beneficiaries of the Risk-On Trade

In the past week or so, the tone of the summer rally has moved from lower-risk/stable stocks to more economically sensitive areas of the market. Two names that I wrote about in April that are lower this week (as a result of the risk-off, selloff in the second quarter) and poised for a catch-up rally are Alcoa ( AA) and State Street ( STT).

Alcoa is a well-run aluminum giant but in a commodity-driven, cyclical business. Recent global macro weaknesses have weighed on international volumes, prices and margins. The stock has struggled in this time of weakness. Nevertheless, management continues to rationalize the cost structure and improve the long-term margins. Aluminum demand continues to grow due to record commercial aerospace orders and the increased use of aluminum for energy efficiency in autos, trucks and commercial buildings. Alcoa should be a beneficiary of global markets moving from a risk-off trade to a neutral or risk-on trade. Management has maintained that part of the weak aluminum pricing this year was caused by bearish global economy speculation on the London Commodity Exchange. As this reverses, look for a pick-up in aluminum prices. Further, upcoming actions to re-ignite the Chinese economy should further aid aluminum demand and pricing.

Global metals and mining consolidation should continue, which could surprise investors in the upcoming period as the M&A markets begin to revive. Based on earnings and asset values, one could easily see Alcoa trading for well above 1x book value of $12.75 per share. The stock has historically sold for 1.6x book value. While Alcoa has been more volatile than the market, the current depressed levels indicate that volatility works for current investors.

State Street is another well-run institution but in the macro-sensitive capital-markets business of asset management, custody and interest rates. Continued volatility in global stock markets and record low interest rates have compressed margins, earnings and earnings growth rates. Fortunately, management has been very successful at winning a record number of new business mandates, acquiring international competitors at attractive prices and significantly reducing the cost structure by several hundred million dollars per year. These strategically sound business initiatives combined with a green light from the Federal Reserve to boost dividends and stock-repurchase activities should enhance returns to investors in the upcoming years.

The greatest boost to value will be an eventual rebound in short-term interest rates from the sub-50-basis-point level today. Management estimates that every 100-basis-point rise in interest rates would add $200 million to earnings, or about $0.30 per share, after taxes. Management believes that in a more normal rate environment (3% Fed Funds rate and 5% 10-year Treasury note rate), return on equity would be 12%-15% vs. the current 10% ROE, an incremental $0.80 to $2 per share. With the stock trading at 9.8x forward earnings estimates of $4.25, investors should enjoy robust capital appreciation potential in the upcoming years since the shares have historically traded for more than 15x earnings.

Both Alcoa and State Street should be significant beneficiaries when the investment world starts looking for and evaluating companies on a more normal, rather than stressed, basis.