Shares of Vale (VALE) have declined 11% this year in a move that erased $10 billion in shareholder value. In this article, I will examine this price decline and put it into the perspective of five years of fundamental data. My concluding recommendation is that further weakness is entirely possible, and shorting the security or selling shares is the prudent course of action in light of the deterioration of firm performance.
Returns Are Key
The first element I have relied on throughout this analysis is return on equity and return on assets. These figures examine the profit of the firm in light of assets and shareholder equity. Return on assets shows the organizational efficiency at transcribing assets into profits. Return on equity shows the managerial effectiveness in utilizing directly invested shareholder equity to generate a profit. The following chart shows five years of history for these two figures.
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The investor should first note the trend in each of these two figures. Between 2008 and 2009, return on assets and return on equity declined until a temporary time of stability in 2010. This period of decline represented a time when Vale was unable to generate increasing profits from its assets and shareholder equity. The firm was still profitable, but it was experiencing a decrease in profitability as time progressed. In 2010 and 2011, return on assets and equity increased in a beautiful trend in which the firm more than doubled each of these ratios. This period was a time of high profits in relation to assets and equity, and shareholders increased the value of the firm by 15% during these years.
In the middle of 2011, however, Vale began to suffer from a return standpoint. Ever since mid-2011, return on assets and return on equity has declined. This decline essentially means that the firm is still able to generate profits, but the profits are decreasing in relation to the assets and equity required to generate the profits. The firm has demonstrated an inability to reverse this decline in effectiveness for the past four quarters, and unless the decline is thwarted, further erosion of shareholder value is warranted.
Not only has the firm been suffering from a return standpoint, but profitability has also diminished across the past year. The chart below shows five years of profit margins for Vale.
Profit margin is essentially the percentage of revenues that the firm is able to keep as profit after accounting for expenses. As profit margin decreases, it essentially means that the firm is decreasing in effectiveness at fighting competitors or controlling expenditures. Since the first quarter of 2011, profit margin has been steadily decreasing. This decrease has been punctuated by 47% decline in share price.
I believe that not only was this decline appropriate, but it is less than warranted from a fundamental perspective. Profit margin was 50% in 2011 and it is currently 22%. This is a 56% decrease in profit margin as measured from one percentage to the other. I believe the market understands this and valued the organization by decreasing share price roughly that amount. However, I do not believe the market has fully priced in the erosion in return on assets and return on equity. Not only has the firm decreased its ability to defend its competitive edge by 50%, but it has also steadily eroded its effectiveness with shareholder equity and efficiency with firm assets. I believe this erosion will lead to further declines in share price in the future.
Despite my bearish stance on Vale, I believe that a healthy dose of practicality is in order. The stock has been in a strong downtrend for the past 18 months. It is entirely possible that this article will be published at the bottom of the trend and will be another case study in the public consistently incorrectly timing the market. This said, I do not believe that investors should go out and short the stock or sell their shares today.
I believe that, at the moment, the best course of action is to do absolutely nothing. In order for this bearish analysis to be correct, I require that the market actually agree with my synopsis. I measure this as continued momentum in the downward trend. If prices are unable to knock out the yearly lows in the stock, then I see no reason to short the security. That said, I believe a sell stop at $15.50 will put the nimble trader in position to profit from further erosion in shareholder value. Additionally, for individuals who are currently holding the stock, I believe this is an excellent location to consider selling some or all of your shares. If price falls below this location, then the stock has proven that the downwards trend is still in motion and that holding shares is fighting the market. The chart below shows the extent of the current downtrend and the support line near $15.50, which, when broken, will signal a short trade in Vale.