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Oil and gasoline prices have had a great run and many oil companies such as Anadarko Petroleum have benefited from the rise. The commodities market is extremely volatile and instead of selling any oil and gas company and paying capital gains taxes, a better strategy is to hedge it with another company that may benefit from falling oil prices. Many oil companies already hedge against falling prices by using the futures market. Some larger integrated oil companies hedge by owning industries such as checmicals that benefit from falling oil prices. As an investor, it is prudent to maintain a diversified portfolio to minimize risk. If you own shares of oil companies, consider hedging with an airline.

Airlines, however tend to be terrible investments due to their low profitability and high risk. One airline however, stands out as a good investment and a good hedge. GOL Linhas Areas Inteligentes S.A. (GOL) stock has strong revenue growth, relativeily low expenses and generates good cash flow. It has higher profits yet suprisingly has lower risk compared to some U.S. carriers such as Continental Airlines 1.

The company is located in Brazil so the shares trading under the Symbol (GOL) represent the ADR (American Depository Receipt). The Brazilian and South American economy is expanding rapidly and so is the company. Revenue growth has growth an astounding 41% annually over the past 5 years. This growth is being driven not only by the roaring South American economy but also the airline's low cost low fare model which has not sacrified service. GOL was awarded Best Airline in the world in 2005, according to the Aviation Week and Space Technology. The stock is still a bit risky so one should consider buying less of this company to hedge against another oil company.



Company: GOL Linhas Areas Inteligentes S.A.
Trading Symbol: GOL
Date of Recommendation 6/22/2007
Risk High
Stock Price as of Recommended Date 33
Fair Value 39
Discount of Price vs Fair Value: 15%
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Bears Say We Say
The operating margins have been compressing. The margins were 43.18%, 34.40%, 38.67%, 27.98%, 28.18% for the respective quarters of Mar 06, Jun 06, Sep 06, Dec 06 and Mar 07 respectively. The last 2 quarters have shown signficiant contraction in the margins compared to previous quarters. If this trend continues, the stock price will go lower. The margins have been compressing due to costs increases especially in its fuel and wages. Wages have grown faster than the rate of fuel, however, fuel is 41% of GOL's expenses and wages are 13%. As fuel prices have gone up, margins have contracted. If fuel prices go back down, then GOL will benefit from lower expenses and its margins will improve. That is why this stock is a good hedge against existing oil positisions.


Assumptions
Expected Annualized Revenue Growth Over Next 24 Months 25%
Expected Annualized Revenue Growth Over 36-120 Months 5%
Expected Annualized Revenue Growth Over 120+ Months 4%
Expected Future Gross Margins 33%
Future Beta 1.75
Assumed Capital needed to grow sales by $1 $.4
10 Year Bond Yield and Weighted Cost of Capital 5.17% and 10.3%
ROIC in excess of WACC for 120+ months forecast 1%
Depreciation and Depletion Life 17 years for PP&E


A Note About Hedging

Many investors use sophisticated models to properly hedge a portfolio. However, these models have often times proved wrong because the models are built using past behavior. The correlations that exist in the past may not work out in the future. Google "Long Term Capital Management" if you want to find out more about a failed hedge fund that relied on hedging strategies to justify enourmous amounts of leverage.

Using GOL to hedge an existing oil position without some serious statistical models may be difficult to achieve. For a simple hedge it might be prudent just to look at the Beta. Since the Beta of GOL is 1.75, one should buy about 57% of an average S&P company due to the high risk. For example, Microsoft's Beta is 1 so if you own $1000 of MSFT, maybe buy $570 of GOL. Or more directly, if you own $1000 of Anadarko with a Beta of 1.2 consider buying (1.2/1.75) $685 worth of GOL.

Don't expect the hedge to work perfectly. In fact just be happy if the price of one down, the other goes up. Over the long run, buying two good, well run companies should pay off whatever happens to the price of oil.



Footnotes
  1. Risk is determined by comparing the relative implied volatilities. The implied volatility of GOL is 35% vs Continential Airline volatility of 45%. Implied volatility is derived from stock option prices and measures how much the option market anticipates the stock to move up or down. The higher the implied volatility, the more risky the stock.