Why I Think These 2 Commodity Stocks Will Make You Money
Investors have been fretting about a weaker economy and the implications for economically-sensitive assets such as steel, copper, iron ore and other commodities. Indeed, the underlying spot prices for several key commodities are at multi-year lows and stock prices of commodity-sensitive companies have also been quite weak.
Yet I continue to think such a backdrop spells opportunity.
Did I think these stocks were poised for an imminent rally? No. I only believed they represented the chance for great multi-year gains and, equally important, likely carried a solid degree of downside protection. How has this view played out?
Even as the global economic outlook has weakened considerably since the start of the year, this economically-sensitive stock has fallen less than 10%. Crucially, with this stock price near tangible book value (of about $8.25 a share) I don’t see a lot more downside. I’ll take that. And though I doubt shares will hit the $40 mark anytime soon (which is where they traded back in 2007), a move to $15, $20 or even $25 looks to be in the cards in a year or two. This kind of positioning is in keeping with my portfolio strategy: “Look for stocks with limited downside but potentially long-term upside.”
What about Freeport-McMoran? Since I added this stock to my portfolio in late April, copper prices have fallen from roughly $3.65 a pound to a recent $3.35. Shares have fallen from $37 to $32 since then, which I’m not happy about, but also see as a small downward move in the context of a potentially more robust long-term gain.
Completely different drivers
Though both of these commodity-sensitive stocks are surely affected by the current scary economic picture in Europe, the factors that will help determine future performance are quite different.
For Alcoa, a rebound could only come when global aluminum demand exceeds supply. I recommended this stock in January precisely because the Chinese government was signaling plans to curtail domestic aluminum output, as the manufacturing process is very energy-intensive. Alcoa, which has the lowest-cost smelters in the world, stood a chance to greatly benefit from supply reductions by rivals.
The company even showed its own industry leadership by announcing capacity cuts back in February. Trouble is, China never followed through on its promise, so supply has not been cut to the extent that I had expected. Yet it’s crucial to note that Alcoa is currently operating at break-even in the context of current spot aluminum prices (of about 82 cents per pound), while major rivals are operating at a loss, due to their higher-cost smelters. As a result, I still expect to see industry capacity cuts in coming quarters and eventually a solid rebound in demand. When that happens, this stock will likely go considerably higher, perhaps 100% of 150% above current levels.
The global picture for Freeport McMoran differs. The copper market is actually quite undersupplied right now and key copper inventories are dropping. The fact that copper prices — and this stock — are falling is solely due to fears of an ever-deeper economic slowdown.
Yet even a drop in demand may still keep this market undersupplied, so copper prices should stage a solid rally when commodity traders come to see that a copper glut has not emerged. That should light a fire under this stock, though I caution that it may not come before 2013. And this stock could slip into the upper $20s before any such rally kicks in.
A shared virtue
The key appeal for these two stocks is the nature of their assets. Alcoa operates the world’s most advanced network of aluminum smelters and a set of appealing downstream businesses as well. Freeport-McMoran owns some of the most productive copper mines in the world, and notably, geologists believe we’ll be past the peak point of supply for copper within a few years as the world’s most productive copper mines start to play out. So Alcoa and Freeport-McMoran are sitting on a world-class set of assets, which again, provides support to shares in scary economic times.
Risks to Consider: Though Alcoa appears to have solid support in the current $8.25-8.75 range, Freeport-McMoran is a bit more volatile and, as noted earlier, could move another 10% to 15% lower from here before any eventual rebound.
Action to Take –> On these companies’ upcoming quarterly conference calls, listen closely for discussions of industry supply and demand. Alcoa has deep insights into global supply trends, so management’s commentary will likely set the tone for the rest of the year. Freeport-McMoran is likely to continue to highlight the fact that copper demand still exceeds supply, even as the global economy stinks.
I don’t anticipate either of these companies delivering second-quarter results that will ignite shares. Instead, it will be the broad investor sense that the European crisis has (at least temporarily) been contained. Or it may be the expectation that the new round of Chinese economic stimulus will bolster commodity prices. In a nutshell, the backdrop for these stocks is simply lousy right now, which is why I find them so appealing. You only make money in commodity stocks when they are deeply out of favor.
– David StermanSource: StreetAuthority
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