Sunday, May 26

Week 99 - Gold and Copper Miners

Situation: Commodities are having a bad year. People who regard gold as a currency, or a safe haven in times of market turmoil and recession, are finding that the US economy is recovering. The great fear that “inflation is just around the corner because the Fed keeps printing money” hasn’t materialized. The Federal Reserve’s preferred inflation indicator (personal consumption expenditures) continues to moderate and is now 1% (year-over-year). People who regard copper production as being so essential to infrastructure investment that they refer to it as “Dr. Copper” are again correct. 

Taken as a whole, the economies of the world are slowly emerging from a slack period. (Dr. Copper reflects that fact.) Yes, the US economy is growing at 2%/yr but European economies are shrinking 2%/yr and Asian economies are struggling to grow 4%/yr--somewhat slower than their former pace.

The great mining companies of Australia (BHP Billiton and Rio Tinto), which mainly export iron ore to China, are shelving their expansion plans (read this link). Whereas the production of most commodities couldn't keep up with demand just a few years ago, supplies now exceed demand. Spot prices continue to fall and production cutbacks are reported almost monthly. Copper production mainly gets warehoused. What to make of all this? Input costs are facilitating the production of finished goods instead of constraining production.

But investors know that infrastructure spending has to increase soon, given that the world’s population increases by 220,000 a day. They also know that governments will engage in deficit spending, and central bankers will engage in “easy money” policies, as long as sub-par growth crimps tax revenues. So gold and copper producers aren’t about to close up shop. Spot prices for gold and copper are simply in the downward phase of what economists like call “reversion to the mean.” The upward phase will resume when economic growth returns to Europe because that's where the bottleneck is located. The BRIC countries (Brazil, Russia, India, and China) are the engine of globalization; those countries cannot grow unless they export a growing volume of goods to Europe.

For this week’s Table, we’re using the recently released Barron’s 500 list as our guide. That list weights 3 items equally: 
   a) sales growth for 2012, 
   b) median "cash-flow based" return on investment (ROIC) for the past 3 years, and 
   c) cash-flow based ROIC for 2012. 
Here at ITR, we view those factors above all others in assessing current Finance Value.

All of the mining-related companies on that list are in the Table. We have also included two railroad companies that play key roles in North American commodity production--Canadian National (CNI) and Union Pacific (UNP)--as well as Caterpillar (CAT), which is the dominant manufacturer of mining equipment. Three gold producers also make the list: Goldcorp (GG), Barrick Gold (ABX), and Newmont Mining (NEM). In addition, the two largest copper producers are included: Freeport-McMoRan Copper & Gold (FCX) and Southern Copper (SCCO). Remember, where copper is found there will also be some gold (and vice-versa). Pure gold emerges as a by-product when copper is purified by electrolysis. 

Bottom Line: Commodity producers have large fixed costs, and that kind of investment only happens when a commodity becomes expensive because it is in short supply. This raises input costs, putting a brake on production and driving up the cost of finished products. Once production expands, however, the opposite happens. This “commodity cycle” typically last for ~15 yrs. For gold and copper, we’re at the end of one cycle and looking to start another when Europe emerges from recession. 

You, as someone who is saving for retirement, probably have a shorter horizon and shouldn’t be investing in commodity producers. The price swings are simply too great. But if you can’t resist the temptation, stick to a low-cost commodity mutual fund such as T. Rowe Price New Era fund (PRNEX in the Table). Better yet, invest in the lowest-volatility railroad stock (CNI) or the lowest-volatility oil stock (XOM).

Remember, the whole point of commodity investing is to participate in the long and strong up-periods of the commodity cycle. The problem is that the down-periods get recognized belatedly and suddenly. That means you probably won’t be able to sell in time to realize a good profit. You'll want to find a company that lives off commodities but also makes money during recessions. For example, railroads haul everyday essentials; integrated oil companies operate gas stations and produce petrochemicals that are used to make plastics.

Risk Rating: 9.

Full Disclosure: I have stock in CNI, XOM, and CAT.

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