Sunday, August 30

Week 217 - Metals and Mining Companies with Improving Fundamentals

Situation: We’re always on the lookout for improved business conditions in companies that depend on “long-cycle” commodities. “Green shoots” are now popping up for those that use rocks and minerals as their main feedstock. Why should you care, since all classes of commodities have been falling in price for some time now? Our reasoning is that you need to follow commodities, if only from a distance, because their prices often respond to factors unrelated to the business cycle. What this means is that commodities can help balance risk associated with stocks and/or bonds. Commodity-related companies represent what’s known as “non-correlated assets.” Their stocks have particular value as moderators of portfolio performance. The reason for this is that commodity production carries large initial fixed costs and usually requires extensive logistical networks, but those large “costs of entry” also discourage competitors, so companies have an opportunity to build a strong brand if not a wide moat. There are risks. Once a commodity is found to be in short supply, it takes years to expand production (because of those large fixed costs), by which time shortages may have been corrected through innovative technologies or product substitution. The commodity’s price may fall because of innovations, substitution and newly expanded production. This will make it difficult to justify further investment but also makes it easy for strong companies to “buy out” weak competitors. Possibly one or two of these strong companies will become responsible for further innovation and substitution, then earn profits that exceed those of its competitors. Any excess of the commodity will likely be placed in storage because dialing back production (to meet demand) will not happen fast enough to prevent a precipitous drop in prices.

Mission: Identify large metals and mining companies that are showing steady improvement in Return on Invested Capital (ROIC) and revenues.

Execution: We’ll start with the Barron’s 500 Lists for 2014 and 2015, which rank the 500 largest companies traded on the Toronto and New York stock exchanges by revenue. Those rankings “compare companies on the basis of three equally weighted measures: (1) median three-year cash-flow-based return on investment; (2) the one-year change in that measure, relative to the three-year median; (3) sales growth in the latest fiscal year.” Eight metals and mining companies had a higher rank in 2015 than 2014 (see Table). Only one, Nucor (NUE), is an S&P Dividend Achiever, meaning its dividend has been increased annually for at least the past 10 yrs. Interestingly, all but Southern Copper (SCCO) carry a “buy” recommendation from S&P and/or Morningstar (see Columns T and U in the Table). With respect to our favorite performance metrics, these 8 companies as a group (see Line 10 in the Table) have greatly out-performed the S&P index fund for metals and mining companies (XME) at Line 19 in the Table

Bottom Line: These 8 leading metals and mining companies are in recovery mode after a bad decade. While their stocks represent speculative investments by any standard, they also carry modest valuations, selling at 1.8 times book value vs. 2.7 for the S&P 500 Index (see Column K in the Table). However, most of the companies in the metals and mining sector ETF (XME) have yet to show signs of recovering from a deflationary decade and sell at only 1.4 times book value. It still remains to be seen whether the world economy will be successful at emerging from the deflation that followed the Lehman Panic. But if it is, most of these companies will double in value over the next two years. Caveat Emptor: these are speculative stocks; none are suitable for inclusion in a retirement portfolio.

Risk Rating: 9

Full Disclosure: I recently purchased stock in Alcoa (AA).

Note: Metrics in the Table are current as of the Sunday of Publication; those highlighted in red denote underperformance relative to our key benchmark (VBINX at Line 16 in the Table).

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