Income Investing Strategy For Freeport McMoRan

Dec.22.11 | About: Freeport-McMoRan Inc. (FCX)

By Mark Bern

For readers who have been following the series I must explain that I am replacing BHP Billiton (NYSE:BBL) with Freeport McMoRan Copper & Gold (NYSE:FCX) due to the continued lack of volume on the options available on U.S. exchanges. In an attempt to keep things simple for investors I have elected to limit our transactions to U.S. based exchanges. That makes large foreign companies available only if the stock is traded on a U.S. exchange (ADRs) and has adequate volume traded both for the stock and the options. FCX fits this description better the BBL.

For readers who have not been following this series if you find yourself curious and want to understand more about the strategy, please consider reading my original article that explains it in detail.

So, first I must explain how we did with our original trades on BBL dated back on October 13, 2011 . The price of the stock that day closed at $61.39 and we sold a December $55 strike put at a premium of $1.90. That gave us $190 minus the commission of $9 for a net cash receipt of $181 or a 2.9 percent return on cash held for 65 days. If we annualize the return using the method described in the original strategy article we would come up with a return of 14.5 percent. Since the option expired worthless we get to keep the premium. Now it’s time to do something else with that money.

Why FCX? With fears about potential inflation still lingering, gold is not likely to fall in price too precipitously. As the global economy picks up some steam, demand for the three main ores that FCX mines (Copper, Gold and Molybdenum) should rise again. Commodities have fallen in price ravaging the price of the company’s stock giving investors a better buying opportunity. Also the company pays a decent dividend (one of my prerequisites) currently yielding 2.8 percent and well covered by cash flow. The payout ratio is about 17 percent and very manageable. The company has historically kept the ratio near 20 percent and I would expect it to rise and fluctuate around that level again over the coming years. The industry average payout ratio is 30 percent giving FCX more flexibility in this area.

The company has a debt of only 20 percent of total capital and has been paying down debt consistently over the past three years. The industry average ratio of debt to capital is about 18 percent. FCX boasts a net profit margin of about 23.4 percent compared to the industry average of 22.6 percent. Return on total capital is 30.5 percent which compares very well to the industry average of 19.5 percent. Return on equity also compares well at 37 percent to 24.5 percent for the industry as a whole. Thus, the company stands out within an industry that I believe has been beaten down probably more than is deserved. Some will undoubtedly disagree with me on this point but let me explain my reasoning.

In 2009, the combination of lower demand and falling prices caused revenue for FCX to drop by 25 percent compared to 2008 levels. Earnings fell 62 percent in 2008 compared to 2008 and the share price dropped from a high of $63.60 to a low of $7.90, an 88 percent collapse. This was an over-reaction since the earnings recovered by 102 percent in 2009 and by another 56 percent in 2010. Revenues, earnings and the dividend all increased to record levels in 2011 while the price once again has fallen by 38 percent from its high earlier this year.

Now, I won’t try to hide the fact that if one looks at the ten-year (candlestick) price chart the formation this year is almost a mirror image of the beginning of the fall in late 2008. There are a lot of potential black swans that could trigger a global slowdown which would then cause stock prices in general, not just mining stocks, fall further. None of us knows with certainty if any of those events will actually occur, but it is prudent to consider the statistical probability as higher than at this time a year ago. Thus, I have decided to avoid trades at this time that have the potential to resemble catching a falling knife. For this reason I have decided to take a longer duration option position on FCX than is my normal inclination.

My current favorite put option available is the January 2013 $34 strike with a premium of $5.90. That means we collect $590 on each contract we sell and get to keep it if the option does not expire. What I like about this position is that it provides significant downside protection while locking in a 15.4 percent cash payment up front from selling the option or a 14.2 percent annualized return. If the option is exercised and we get put the stock, we will end up with a cost basis of $28.10 which represents a 26 percent discount to the current price of $37.75. It also provides us with considerable flexibility if the market stabilizes. In that case, we would expect the stock price to also stabilize and allow us to buy back the option contracts after the premiums have decayed and still bank a nice profit (probably much higher than the 14.2 percent we currently expect). Then we can reassess the situation and sell more puts with a closer expiration if circumstances then warrant. In this case, I will be selling two contracts to replace the expired BBL contracts. I will leave the BBL stock in the buy and hold portfolio as I like the stock and believe it still has just as much long-term potential as FCX.

For those who are new you can find the first summary article that shows all the positions we have entered and a comparison between the buy-and-hold portfolio of the selected stocks and the strategy portfolio. Both portfolios had nice returns thus far and it should be fun to track them both over the two years I intend to keep this series running. In the next summary article I plan also to include results of the S&P 500 index as a further comparison. I hope you’ll stick around to see how this all turns out. Successful investing to all!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I am considering selling put options on FCX as described in the article.