Seeking Alpha
Value, contrarian, long-term horizon, long only
Profile| Send Message| ()  

Last Friday, Cliffs Natural Resources (CLF) skyrocketed a full 6.08% shortly after earnings per share estimates went from $2.91 to $2.97, which prompted Zack's Investment Research to mark CLF as a strong buy. That was a change from their earlier Dec. 5 neutral rating on the stock. Later in the day, TheStreet.com (the website affiliated with Jim Cramer) indicated that there was a strong level of social media activity with respect to the ticker symbol CLF. TheStreet.com had indicated back in November that CLF might not be a strong buy, which was a change from their summer position on the stock. That indicated one should buy it (as always, we see the mainstream stock analysts' constant change on stock valuation without respect to any real change in value).

It was only a week ago, however, that right here at Seeking Alpha a fellow contributor was compelled to write the article "Cover Your Ears And Buy Cliffs," which, on Dec. 18, was a properly titled article given the depressed view that many analysts had on CLF. So why was there this change in perspective by the mainstream analysts? Has an annualized change in EPS of only $0.06 and a more positive rating on the entire iron ore industry really managed to change the intrinsic value of CLF by that much?

The answer is no. There were many solid indicators of value that should have driven an investor to purchase CLF based on a value investor paradigm and that drove me to purchase it over a month ago, when analysts were speculating that CLF was a poor buy or at best a neutral buy. The mere change in EPS that recently occurred and the increase in social media mentions -- while certainly a welcome thing to any CLF investor -- should not be the type of short-term data that causes a person to either buy or sell any stock, including CLF. So, here are the three simple reasons for purchasing CLF that have not changed within the last 24 hours and have not changed during the last month.

1. P/E Ratio. To followers of CLF, any statement about the P/E ratio probably seems ridiculous. EPS was -6.57 last year. How does one know to buy this share based on a ratio that states the positive price divided by a negative denominator? Well, you can't know to buy it based on one year of earnings or trailing 12 months earnings. Instead, you do as Graham and Dodd suggest and take the weighted average of 10 years of earnings as your denominator and cyclically adjust it for inflation, as Shiller (the recent Nobel Prize winner) suggests, and essentially take the CAPE ratio (cyclically adjusted P/E) for the stock. There is a handy calculator for the small investor to calculate the CAPE ratio, which indicates that the ratio for CLF currently stands at 4.51. That would indicate that compared to 10 years of earnings the stock is probably undervalued considerably.

2. P/B Ratio. On Dec. 26, the P/B for CLF was 0.7586 and after the 6.08% increase in price CLF now has a P/B ratio of 0.8047. For the value investor, the P/B ratio is very important and was, of course, the favorite of value investor Walter Schloss. At 0.8, the P/B ratio is showing that if CLF went bankrupt tomorrow, then it would be able to return $1.25 per $1.00 invested back to its equity holders (with lawyer fees not taken into account, of course). CLF is not about to go bankrupt, however, and it is in fact seeing positive EPS in recent quarters despite the negative number for last year, as indicated above, that has caused a depressed price for most of the current year.

3. Management Change. It follows that something at an organization must change in order to have a positive turnaround. So, in the vein of Peter Lynch and Warren Buffet type of thinking, we can see that there was a change at Cliffs Natural Resources in the top position. Joseph Carrabba retired on Nov. 15 and was replaced by Gary Halverson on Nov. 18. This will most likely be a strong positive in favor of those purchasing CLF (and which caused me to purchase it a month back). Change in management can be good, but it can also be bad when one considers that an investment in CLF based on the P/B ratio or a modified approach to the P/E, which could discount the bad final quarter of last year. One can quickly see that CLF had many positives besides just the recent change that either TheStreet.com or Zack's might have shown.

A wise investor who looks at the long term and buys severely discounted stocks would have been considering CLF quite some time ago, knowing that the downside was well-protected and that the upside had high potential. However, if one was only interested in short-term investing strategies, then one can ignore the above analysis and simply recognize that many Quant Traders use the P/E ratio heavily in their analysis (the trailing 12 months P/E ratio). For the last 12 months, the P/E ratio has been contaminated by the negative quarter of December 2012 at -$11.36. This contaminates the subsequent positive quarters of March 2013 at $0.66, June 2013 at $0.87, and September 30 at $0.68.

Now the price of CLF is going up based on short-term-thinking investors and various analysts stating that the current year will be slightly more positive than expected. Or did the analysts simply use the small change in current EPS as an excuse to change their short-term expected price toward the positive, because they know that soon the P/E ratio for trailing 12 months earnings will be higher (not due to a recent change in annualized EPS of $0.06 but the falling off of the final 2012 quarter at -$11.36, which will cause many programs to start purchasing CLF)? Either way, CLF was a strong buy months before it was recognized as such by many analysts.

Source: 3 Reasons To Buy Cliffs Natural Resources