Earlier this year as fear of lagging Chinese growth, rising US interest rates, and decreased global demand hit the market the prices of commodities, especially those of precious metals begin to crater. Investors, hedge funds, and short sellers began to flock to names like Freeport McMoRan Copper & Gold (FCX), BHP Billiton Limited (BHP), Vale SA (VALE), Rio Tinto Plc (RIO), and Alcoa Inc (AA) and relentlessly sell. Even harder hit were the gold miners as gold plummeted from a high of $1,650 dropping to a low of $1,180. Names like Goldcorp Inc. (GG), Newmont Mining Corp. (NEM), and Barrick Gold Corp. (ABX) were all taken to the wood shed.
I find the base metal miners to be very interesting to follow and invest in because of their correlation to both the broader global market and their heavy concentration in the emerging markets. This concentration in emerging markets is especially true when it comes to anything China. As the Chinese economy has lost steam over the past two years bigger miners and metal names have seen it directly affect their bottom lines.
As the old saying goes, 'it is always darkest before the dawn', well I think the dawn has finally arrived for the mining sector. Last week, the Chinese manufacturing index reported an unexpected rise from 47.7 in July to 50.1 for August. Now, I realize that a reading of 50 represents an essentially flat number, but given the recent declines that the country has seen any sign of stabilization and bottoming out is a good sign in my book.
Additionally, earlier this month energy production in China was recorded as moving up almost 5.7%. This was another unexpected number coming out of the Chinese economy and is further evidence that the Chinese economy is starting to turn from its previous slowing state to going back into its growth and expansion mode. As optimism begins to shift back toward the emerging markets and China I think we will start seeing it reflected in the market prices of the metal and mining stocks.
After June's 'taper-tantrum' over the Federal Reserve beginning tightening of policy this Fall the market has somewhat stabilized and begun to price in a QE tapering late this Fall toward the end of the year. This adjustment in expectations that the Federal Reserve will not begin its QE tapering in September has also helped the miners and metal stocks which are starting to churn higher as this news is being priced in.
Current Miner Bargains
When it comes to looking for value in the metal and miner sector I am going to focus more on the well diversified miners and not as much on the gold miners, since I try to keep my gold exposure (what very little I have) limited strictly to the commodity itself, so I trade either the iShares Gold Trust ETF (IAU) or SPDR Gold Trust (GLD).
As for the big diversified miners I am usually a big fan of BHP Billiton, but given the recent downswing in the sector I think it is only fair to take a balanced look at all of larger diversified miners. The below chart compares several of the big firms against one another on a fundamental and value oriented basis.
Return on Equity
YTD Stock Performance
YTD Profit Margin
Free Cash Flow
In examining the stocks above the two clear winners to me from a fundamental and financially sound basis would be BHP Billiton and Freeport McMoRan. Both of these stocks are trading down on the year, but both have approached an attractive valuation point. BHP trades for 16 times earnings and has reasonable operating and profit margins. Not to mention the company has a healthy amount of cash on hand. Freeport on the other hand trades for only 11 times earnings, has similar profit and operating margins as BHP, but also sports a more attractive book value and dividend. Of course I realize that all of the above metrics are backward looking, but assuming that emerging market and global demand begin to increase I think it is safe to assume that metrics in these miners have hit a bottom at least in the interim.
Both of the above mentioned stocks are good stocks, but each stock really is for two different types of investors in my opinion.
· BHP Billiton I would say is geared more for the risk adverse investor who still wants exposure to the metal and mining sector, but still wants a reasonable margin of safety. BHP is an extremely large well diversified business that is very conservatively managed. In my opinion, buying BHP at $65 per share has both limited downside and limited upside. The stock has extremely strong support at the $58 - $60 per share level, but also has strong resistance at the $80 per share level. Total risk reward on this investment is ideally to generate a gain of $15 per share, while potentially losing $5. This is not a bad risk reward, but again this is not a fast and hot stock, so the $15 per share gain may take several months, if not a year.
· Freeport McMoRan on the other hand is a much more volatile company whose share prices swings quite a bit, especially compared to BHP Billiton. Freeport is about a third of the size of BHP, but buying Freeport here at $31 per share has a little more dramatic risk/reward. Freeport has had strong support at the $26 level, but even in times of high volatility it has swung all the way down into the low 20s and teens. The brightside is that Freeport has the potential to trade up into the mid $40s very quickly, so the gains can be realized much faster than that of BHP. Overall, Freeport has the potential to lose $5, but make $15 too.
Even though both the up and down side risk amounts are the same for both Freeport and BHP it is important to mention that the percentage swings that each stock might encounter are entirely different. BHP has the potential to lose an investor at its current price 7.6%, while Freeport could lose up 16% at its current market price. On the flip side the upward potential for Freeport is much higher at 48%, while BHP would only generate 23% based on the upside ranges that I outlined above.
Personally, I like both Freeport and BHP and think that both are poised to pop in the months ahead as the Chinese market continues to stabilize and demand for commodities begins to rise again. Both are currently priced reasonably, with Freeport being the better deal of the two.
For anyone that wants to bet on the return of the emerging economies and especially the Chinese economy either one of these names in my opinion would be a strong bet. Not to mention that both pay attractive dividend yields, so even if it takes longer than forecasted for these markets to stabilize you are still being paid to wait.