My Favorite Stock in the Natural Gas Group

Happy New Year!

The Tax Man Cometh

A Turn in Natural Gas?

First and foremost, I hope you had a great holiday season thus far, and I hope you have an even better New Year. The end of the year is a time for reflection and, for many of us, to be thankful for what we’ve accomplished.

For myself, this is a job I wake up every day looking forward to—writing about the stock market and, with some luck, helping subscribers make a few bucks. And it’s not lost on me that I wouldn’t be able to do it if I didn’t have many people who wanted to hear my advice! So consider this my heartfelt thank you for allowing me to do something I really enjoy.

Another thing I like to focus on at year-end is simply staying humble. Yes, this was a great year for many investors, but most of us have seen things go the other way, too. Whether I’ve had a great year, a so-so year, or a really bad year, I like to remind myself that making and keeping money in the stock market is very difficult. If it were easy, everyone would be rich, but of course they’re not.

Every day, week, year presents its own challenges in the stock market, which is part of the fun of it. But the good news is that, win, lose or draw, the market will provide another set of opportunities next year. So if you’ve had a big up year, enjoy it! … but be sure to stay humble because the slate is wiped clean as the calendar turns.

Conversely, if you’ve underperformed or had an outright bad year, don’t despair—you should use this quiet(er) time in the market to study your two, three or four biggest mistakes, find commonalities between them, and then write out some rules for yourself so you don’t repeat them. (A couple of so-so years in 2011 and 2012 taught me to avoid nearly all stocks that are thinly traded; my track record with them was horrible! Avoiding some of those pitfalls has helped my results this year.) The point is that there’s always another chance to improve in the market; take the opportunity to do so in 2014. As always, I’m here to help the best I can along the way. Cheers!

Now on to a more topical subject … taxes. This time of year, I can’t go a day without hearing from a subscriber who, when considering booking some profits, says something like “but my accountant would go nuts if I sell stuff now; I’ll be on the hook for $XYZ in taxes!” While I am someone who really approaches the market as a purist—just making the best decision I can based on our system—I do understand the tax conundrum. After all, the goal is to make money, and taxes play a role in that.

Some investors look at the weight of short-term capital gains taxes, which are taxed at ordinary rates at the Federal level, and decide they should try to hold stocks for at least a year (when the favorable tax treatment kicks in), or focus more on dividends or slower-moving names. But I’d be careful with that thought process—there’s nothing wrong with holding slower movers for a long time, but you don’t want the tail (tax considerations) wagging the dog (stock selection). You want to own the best merchandise in the market.

So what’s the alternative, besides getting zinged by Uncle Sam every time you have a good year in the market? My advice is, for 2014, plan ahead of time for the taxes you’ll owe a year from now. How? First, I like to make a couple of assumptions: One, that I’ll make money over time (during the next few years), and two, that I’ll pay taxes at short-term rates.

Here in Massachusetts, the state actually zings you 12% for short-term capital gains (!), and if you’re in the 28% Federal tax bracket, that adds up to 40% of all short-term capital gains out the window. (Yes, I do think that’s way too high, but let’s avoid the politics and just accept that it is what it is.)

Thus, using this example, what I would do is assume that your risk and reward is really only 60% of what it seems (the other 40% going to the tax man). Example: If I buy $10,000 worth of a stock, and use a loss limit of 12%, I am “risking” $1,200. That’s my risk of loss if the stock goes straight down after I buy it, day after day, and then stops me out a few days later. A $1,200 loss.

However, assuming that you’re going to make money over time (and, hence, pay taxes to the government), the after-tax loss is really only 60% of that … or $720. The rest will be “written off” against other capital gains. Of course, this is assuming you’re trading in a taxable account, and it’s using Massachusetts figures—be sure to figure out your own tax rate for Federal and state.

The point is that, while you think you’re risking $1,200, in the long run, this trade really only has an after-tax risk of $720. (Naturally, the opposite is true, too—a $1,200 is really, in the long run, only good for $720.) Thus, you can actually take bigger positions than you normally would, knowing that the government is going to take away some of your gains, but also provide higher write-offs for your losses. That way, your portfolio management plan already takes into account any potential taxes, and you don’t have to fret about it every November and December.

Now, you still need to keep risk in check—taxes or no, you shouldn’t risk more than 2% of your portfolio per trade (preferably a lot less, something in the 0.5% to 1.5% range). You don’t want to lose 50% of your entire portfolio and say, “hey, I’m only really down 30%!” That’s still a ton of money, and could take years to recoup. The real key to long-term stock market success (really, long-term financial success) is to lose small and win big. Remember that.

However, if you have confidence in your investing style and you’ve been consistently risking, say, $1,000, you can consider bumping that up to maybe $1,200 or $1,250, realizing that Uncle Sam (and your state) are going to share in your profits and losses over time. Feel free to respond to this email if any of these numbers or talking points confuse you—it’s not overly complicated, and I’ve found it can help you focus on after-tax returns.

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As for the market environment, well, frankly, it’s very giddy—sentiment is through-the-roof bullish, and most stocks are levitating higher on typical light volume, holiday trade (though a few growth stocks have been hit hard the past couple of days, which raises an eyebrow).

There’s nothing wrong with the action, but (a) risk is elevated, as the trend is stretched and lots of investors who were staying far away from stocks early in the year are now pouring money into funds, and (b) there aren’t many lower-risk entry points I can find among growth stocks. I’ve basically been in a holding pattern in recent weeks; sitting tight with stocks that are acting well, doing a little new buying on weakness here and there, but really not pushing too hard in either the bullish or bearish direction.

For new buying, I am looking for names that have been building bases for the past many weeks—I’m not really interested in chasing something higher at this point, but I do see many growth-ier stocks that are still forming bases and could lift to new highs during January if things break right.

One group that I’m intrigued by is natural gas stocks. Admittedly, I’ve dipped my toe into this area a couple of times in recent years, with no great success or failure; each time, sagging natural gas prices weighed on the group. However, it now looks like natural gas prices etched a multi-month bottom in the $3.30 to $3.50 area, and the latest gallop to $4.50 or so makes it look like the longer-term trend could be turning up. I’m less concerned with a new uptrend, though, than focusing on the fact that prices aren’t likely to plunge anew.

That’s huge news for my favorite play in the group, Cabot Oil & Gas (COG)—no relation to us. I almost never use the word revolutionary when it comes to an energy stock, but the amazing returns Cabot is generating in the Marcellus Shale in Pennsylvania, along with its vast, multi-year growth potential, are almost hard to believe—production has been growing at 50% annual rates, and 2014 production growth is targeted at 35% to 50%. And, even at prices of $3.50 for natural gas, its returns on its wells are north of 100%!

Moreover, the company recently announced a new well pad experiment, and the results were outstanding, with solid output but, more importantly, about 10% lower costs per well drilled. That will boost returns even more.

Lastly, Cabot is one of the few drillers that are starting to produce free cash flow (most have to plow all of their cash back into new wells). It pays a token dividend, but with management firmly believing the stock is undervalued, it went ahead and bought back about 1% of the company this quarter. Whether the free cash flow in 2014 is used to buy back shares, boost the dividend or accelerate its drilling program, it will be all to the good for shareholders.

As for the stock, COG topped around 40 in September and slipped to 32 in November; at that point, shares had made no progress since early March. But the stock’s begun to perk up of late, pushing back into the upper 30s, giving the chart a nice, proper rounded look.

Because it hasn’t broken out (and the RP line is lagging the price somewhat), I’m not pounding the table here; COG might need a few more weeks to consolidate, or it might fail here. But I do love the story, and the action of the stock and of natural gas prices is encouraging. Keep it on your watch list, or, if you prefer, you could start with a half-sized position here (stop around 35) and look to add shares on a decisive, big-volume push above 41.

Sincerely,

Michael Cintolo
Chief Analyst of Cabot Market Letter
and Cabot Top Ten Trader

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