Time to Buy Baidu
Buy Baidu ahead of earnings.
That’s the message coming from the stock market as China’s Internet search giant prepares to report third-quarter results after the market closes on Oct. 29.
Last week, when the U.S. stock market was exhibiting extraordinary price swings, often falling so sharply as to suggest the bull market was ending, Baidu (ticker: BIDU ) swam against the current. Baidu’s shares advanced, as did many China stocks, even as the broad market sunk lower.
On Wednesday, for example, when the Dow Jones Industrial Average fell as much as 460 points intraday, China stocks held up extraordinarily well. The iShares China Large-Cap (FXI ) exchange-traded fund barely budged. Alibaba ( BABA ) traded higher for most of the session. Baidu rose almost $7 on heavy volume. The strength was shocking on a day that ended with the CBOE Volatility Index ( VIX ), the investor’s fear gauge, rising to 30, a level some associate with economic depression.
The Baidu earnings trade is inspired by an old trading trick. When the stock market is one fire, racing higher or lower, seasoned traders look for stocks that are not participating in the move, and find out why.
For Baidu, the source of its vigor seems pinned to earnings. The company is expected to report earnings per share of $9.71 on revenue of $13.6 billion.
With the stock around $212, investors can buy Baidu’s November $212.50 call that expires Nov. 14 for $11. To offset the high price, investors can sell the November $207.50 put that expires Nov. 14 for $7.80.
If earnings propel the stock to $220, the $212.50 call is worth $17.50. Should the stock remain above the $207.50 put strike price, investors can keep the put premium of $7.80.
The strategy of selling a put and buying a call is known as a “risk reversal.” It is used when investors think a stock is poised to advance. The strategy is only suitable for investors willing to buy the stock on a pullback. That’s why investors sell the put.
The strategy reflects a belief that analysts will rerate Baidu’s stock after earnings. Last week, Elia Ji, who covers Baidu for Oppenheimer, upgraded the stock to Outperform.
Ji is telling clients that revenue and earnings should increase based on growth in Baidu’s search engine as well as stronger margin outlook for 2015. Oppenheimer set Baidu’s price target at $280.
“We think the recent market correction provides a great entry opportunity for Baidu, one of the largest Chinese Internet companies, with its leading market share in search . . . and new initiatives well planned to remain a top performer in the industry,” Ji wrote.
Should Ji’s insights prove prescient, the Baidu “risk reversal” will enable investors to profit from the earnings report.