Let's review a little stock market history first. Making annual lists for the upcoming year are a cherished tradition in our society. Wall Street is no different. We love to review the past 12 months and look forward to next year, especially regarding "performance" and returns on a calendar basis. Believe it or not, the biggest crowd following, mainstream business publications often get it WRONG when forecasting future returns, especially long-term ones. Their purpose in life revolves around reporting the recent past (including news and gossip) in an effort to sell as many copies of magazines, newspapers and web traffic banner ads as they can. If business journal success and profitability were measured by forecasted stock market returns for next year, nearly all of them would be out of business today.
Here are some examples of completely failed forecasts the last several years. In late 2011, financials in general, and the big money center banks in particular, were poster-children of the do not own lists for 2012. Yet during 2012 financials and big banks LED the stock market higher, and this trend continued throughout 2013. Today financials as a group when measured by the various sector ETFs are 70% higher than 24 months ago, and the big banks are up between 100% and 150%!
Solar companies, at the end of 2012, were cover story ideas as the worst investments for your money going into 2013 by conventional wisdom business journals. After several years of seemingly endless investment losses, nobody in their right mind would want to actually buy into such a business disaster! As a group, solar stocks bucked the severe price downtrend started in 2010, reversed strongly in the final months of 2012, and skyrocketed in value and price from near bankruptcy investor sentiment levels. Measured by the solar sector ETFs, solar investments more than doubled your money during calendar 2013, and rose better than 200% into the November 2013 highs from their November 2012 low point.
So, which sectors are considered the black plague moving into 2014, after a horrible relative performance span the last few years? That answer should be easy for anyone listening to financial news outlets in late 2013, namely any company mining commodities out of the ground, including precious metals, industrial metals and coal.
Contrarian Analysis for 2014
Without doubt, I would suggest independent thinkers and investors dig around the gold and silver miners for real value in December 2013. I have personally acquired a bigger precious metals stake during November and December, both as a pure contrarian play for speculative gains in 2014, and a way to hedge the unending drive higher in the stock market generally.
Perhaps holding an even better long-term position for investors to purchase right now, industrial commodity mining stocks may be ready to undergo sharp gains in price during calendar 2014. Can industrial metal and coal mining equities rise from the dead, and actually lead the stock market during 2014, just like the financials and banks of 2012-13, and solar companies in 2013? You betcha! Here's why …
The economy and markets are constantly in a cycle of change, with supply and demand fundamentals swaying like everything else in nature. Investor sentiment tends to follow changes in the economic tide, not lead them. Greed and fear exaggerate the stock market swings related to the business cycle, and sector/industry focused emotions work the same. At the end of 2013, we have a unique combination of circumstances you see at major bottoms in a sector. Global demand is increasing for commodities as economic growth picks up in the U.S., Japan and Europe, while mined supply for a long list of products is falling during 2013 vs. 2012 (and are projected to do so again during 2014). That's not all! While this shift to better supply/demand pricing power for commodities is taking place, record, out-of-control money printing on the planet by central banks will likely add to rising inflation pressures in commodities during 2014. But there's more! Investor sentiment about commodity miners is a good six months BEHIND the change taking place in commodity pricing. Wall Street analysts and mainstream investors alike are looking at the oversupply of commodities that existed 12 months ago as a trend continuing throughout 2014. In fact, events on the ground are already improving daily. This mismatch of investor perceptions versus the actual business future of many miners is what creates the oversized price gains in stock quotes into the future.
After we identify the sectors witnessing the biggest positive change in business fundamentals and investor sentiment going into 2014, we then try to find the most undervalued leaders in the sector. Specifically, which companies have a bright long-term future as a result of a strong balance sheet, robust earnings and cash flow at the industry bottom, and/or a micro level refocus on profitability taking place concurrently to capitalize on the trend shift in the larger sector turnaround? The stocks that fit this search the best are Cliffs Natural Resources (NYSE:CLF) and Peabody Energy (BTU).
Cliffs Natural Resources
Cliffs is a large independent miner of iron ore in Canada, the U.S. and Australia generating 85% of company sales, with a minor coal operation in the U.S. accounting for roughly 15% of sales during 2013, based on the latest September quarter earnings report.
Cliffs has a very large short interest position that has served to both depress and suppress its stock price the last year. With some 30% of shares sold short of the outstanding supply, numerous investors are actually betting the company will have problems in 2014, regardless of reality. [Shorting involves borrowing shares from your broker, and selling stock you do no own. You will have to buy back shares in the future to cover your position, hopefully at a lower price than sold today. Short sellers are betting a company's prospects and stock price will decline.] Short sellers are gambling the global economy will stop growing, Cliffs' balance sheet leverage will be a problem for future profitability, and/or iron ore prices will decline from here. I personally believe short sellers will be proven incorrect on all three counts in 2014!
Zacks Equity Research put out a note last week, focusing on the above average value Cliffs shares have as analysts are behind the curve in raising income estimates for 2013-14. The upturn in the global economy, especially in the developed industrialized nations, may catch most every prognosticator off guard soon. The indicators I keep show much promise about U.S. economic growth going into 2014. [We can debate the PONZI money printing foundation and sustainability of such in a later article.] One of the "surprises" for the economy in the first half of 2014 may be robust industrial activity, after five years of stagnation and backpedaling. If we do get better economic demand for iron ore, the falling production volumes from years of mine closures and restructurings in the industry point to sharply higher iron prices. Industry projections of supply highlight the declining trend in production into 2014, about 10% less than 2012 globally.
Cliffs has been shuttering unprofitable operations, through asset sales and downright closures the past several years. Cliffs just announced in November it was putting the development of a chromium/chromite mine in Canada on hold. Cliffs has done an excellent job of reducing operating costs and paying down its long-term liabilities in 2012-13 also. Currently, accounting equity represents better than 50% of the company's total balance sheet capitalization. For a large, low-cost mining operation, this sum of long-term leverage is actually quite normal, and is improving daily.
So what's the upside in Cliffs? I would say the sky's the limit on this name in 2014. Earnings per share potential runs as high as $10+ annually if iron ore prices spike. Cliffs earned $11 a share in 2011, and entertained a stock quote of $100. It can be argued the company's current asset and financial make-up is stronger now than it was a few years ago. Given the stock price is $27 today, industrial metals pricing bottomed in the summer months, and the company was still profitable mining iron ore in 2013 at the trough, it is easy to get excited about the upswing coming for Cliffs investors.
The $27 stock price is well under the $37 book value number projected for the end of December, with a Wall Street consensus of nearly $3.00 per share in earnings for 2013. Cash flow estimates are running just under $7 per share annually on trailing results, with $35 in 2013 revenues per share. For perspective, at the all-time 2008 peak in iron ore prices, Cliffs sold for 7x book value, 4x sales per share, and 15x cash flow. An equivalent valuation at the 2013 LOW in iron ore prices would be more like $120 a share! You can let your imagination roam regarding Cliffs future stock price if iron ore prices rise 50% or more during 2014. The present 2.3% annual dividend yield is a bonus for long-term investors, as you get paid to wait for the capital gains in the stock price!
Charts courtesy of StockCharts.com
During November, I mentioned Peabody in the widely distributed Seeking Alpha article on the top energy stocks to own for long-term investors. There are some good data points, charts, and links to understanding the coal market here.
While the Western industrialized economies are moving away from dirty coal power generation, toward cleaner environment alternatives, it is the option of choice for new plant construction in Asia. The super-low cost of coal electricity generation, looking cheaper each day vs. rising natural gas prices, should keep overall global demand on a decent growth curve for many years to come. All told, coal is a fossil fuel that has a finite supply in the ground, just like oil & gas. After better than one hundred years of active mining and exploration on the planet, the easiest and least expensive coal near the earth's surface is slowly disappearing. On a long-term horizon of a decade or more, coal resources will become increasingly scarce over time, if China and India and the rest of the Asian tigers continue to grow economic demand at clips well above 5% annually. Coal demand from all of Asia, including Japan, is at record levels today and 10% higher than 2012.
Peabody has become a major coal player in Asia with its 2012 acquisition of Macarthur Coal in Australia. It is now the largest publicly-traded coal miner in the world. The company owns 28 mines located almost exclusively in the United States and Australia. Peabody has done a wonderful job reducing its operating cost structure since 2012, to align with the latest drop in coal prices from 2011. Between September and December 2013, coal prices may have put in an important bottom. Overall the coal price is hovering just above its global recession low of 2009, about 30% below the 2010 high quote and 70% below the 2008 spike peak.
If you believe the global economy will continue to advance, Peabody stands in a great position to benefit. As an added bonus for new buyers around $19 a share, Wall Street expectations for 2014 are quite low and ANY bump up in coal prices will sharply increase the profitability and stock price of Peabody. The stock is presently valued at 6x projected cash flow for 2014, around its accounting book value number, and has a 1.8% dividend yield per annum. Wall Street earnings estimates are quite low for 2014, with EPS forecasts in the $0.60 area.
Remember, investor expectations and Wall Street forecasts tend to be rear-view mirror looking. Not many are plugging in numbers for Peabody valuations given a rising coal price environment in 2014-15. If coal demand volumes rise alongside a jump in selling prices, Peabody could quickly see profitability explode above $2.00 per share. Given 2010-11 pricing for coal, Peabody has earnings potential of $4-$5 a share. A spike toward the 2008 all-time highs in coal could generate earnings above $10 a share annually, after accounting for the increased volumes from the acquired Macarthur assets. Considering Peabody was a $70 stock in 2011, the upside potential from $19 a share is quite substantial.
Based on my Victory Formation system, plenty of buying, short covering and accumulation of shares has been taking place since the summer months in both Cliffs Natural Resources and Peabody Energy. With the stock market generally quite overvalued in December 2013, few stocks have honest potential to double and triple in price the next 12-24 months. A number of metals and commodity miners have decent odds to do just that, actually rise substantially in the face of a flat to declining stock market.
Just like First Solar (NASDAQ:FSLR) and SunPower (NASDAQ:SPWR) scored incredibly well in late 2012 on the Victory Formation system, Cliffs and Peabody may surprise to the upside soon. You can read my solar buying excitement article from February 2013 here. Cliffs and Peabody have all the risk-adjusted ingredients today of future big winners. Any upturn in prices for the two stocks will likely provide more evidence that a long-term turn for the better has already taken place. We may look back many years from now, and wonder why we did not purchase more shares at these bargain bin prices.
I cannot guarantee any stock will double in 2014. Plenty could go wrong in the macroeconomic picture to keep Cliffs and Peabody in a basing pattern another year. Nevertheless, investor expectations are so low, and the likelihood (in my mind) of stronger industrial output so high going into 2014, serious long-term investors would be doing themselves a disservice if they ignore the latent upside ready to appear. As always, do your own due diligence. Invest only what you can reasonably afford to lose, given a 50% drop in any equity investment, and still smile about it.
Disclosure: I am long CLF, BTU, FSLR. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.