Why Chase Speculative Commodities?

Bill is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Sumitomo is one of many copper miners expanding capacity as its margins deteriorate. If copper prices decline based on lower demand from ebbing construction or price competition, lower margins become dangerous.

Price competition is a big problem facing commodity producers. Investors should demand cheap valuations for commodity stocks to compensate them for the risks associated with producing a non-differentiated product. Do copper stocks offer sufficiently low valuations?

Sumitomo's Expansion Plans

Sumitomo Metal Mining, one of Japan's largest Copper producers, expects an increase in the processing fees due to the increase in supply of raw materials from the mining fields. These costs which are commonly referred to as TC/RC or treatment and refinery fees for metals such as copper, are likely to rise above this year's level as agreed by other major Japanese players in this industry and Freeport-McMoRan (NYSE: FCX).

Sumitomo President Nobumasa Kermori said, "Spot TC/RCs have been increasing as the yen's strength against the dollar reduced margins for Japanese smelters and Chinese buyers were reluctant to purchase concentrate because of the unfavorable difference between prices in Shanghai and London." Kemori also expounded further on the prospects of Sumitomo Metal Mining expanding its operations globally as it targets three mining fields in South America. The purpose of expanding operations beyond its borders is to attain a production output of 300 thousand tons by 2020, up from the current output level of 120 thousand tons. This target is to be divided into two phases, the first phase being the Siera Gorda Mine estimated to generate 70 thousand tons while the remaining balance will be generated from other foreign mining fields the company plans to acquire.

Copper Miners Need China

Demand for base metals like iron, copper, and zinc depend on the PRC (People's Republic of China) continuing its outsized spending on construction projects.

Will the Chinese government be able to boost economic growth while there are signs of a slowdown in the Chinese economy? Freeport CEO Richard Adkerson is confident that the People's Republic of China will find a way to boost their economy so that output meets the targets of its five-year plan targets.

Freeport-McMoRan Copper & Gold, the largest public copper producer, anticipates continuous demand for copper in China, a view that considers the recent reports of decreasing copper purchases as temporary. In an interview Freeport-McMoRan CEO Richard Adkerson said, "Presently we're not seeing physical evidence of a significant change. Sentiment has certainly changed and the concerns about China both within the country and from outside observers are changing but China continues to consume significant copper."

Goldman Sachs (GS) cut its projections for copper by 11%, but Freeport-McMoRan still has plans to invest in the copper sector and increase production capacity by over 25% in three years.

This show of confidence is to be expected from copper miners who are in the business of developing new mining projects. However, investors have more options than a buy/no-buy decision of copper projects. Thus, investors should have a more cautious approach and should demand lower valuations for copper miners. After all, much of their demand depends on the political decisions of one nation's centrally-planned policies.

Finding Value in Copper

Freeport-McMoRan trades near $39 per share. The firm's 2.12 price-to-sales ratio is typical of today's prevailing market multiples. Freeport-McMoRan shares are trading at an attractive 12.71 price-to-earnings ratio, lower than the 14.23 average of the S&P 500 index. Shares trade at a 2.24 price-to-book ratio which is near the 2.07 S&P 500 average.

Shares of this large cap offer a dividend yield of 3.10% which is much higher than the yield of the 10-year treasury bond. Earnings could drop considerably before dividends must be cut because the company pays out 0.34 of earnings as dividends,

Southern Copper's (NYSE: SCCO) shares are much more richly valued. At $39 per share this large cap copper miner trades at a price-to-sales ratio of 4.92, a 5.01 price-to-book ratio, and a 16.1 price-to-earnings ratio. These price multiples are much higher than those of Freeport-McMoRan.

If these higher valuations were not enough to dissuade investors, a precarious dividend policy should. The firm's 0.72 dividend payout ratio is shaky since this leaves very little room for failure and scarce funds for reinvestment. This calls Southern Copper's hefty 4.30% dividend into question. Downward adjustments of dividend payouts can scare investors and send stock prices lower.

The low valuations for Sterlite Industries (NYSE: STE) at $8 per share are appropriate for this Indian mining stock. It's price-to-sales ratio is 0.79, a fraction of the S&P 500's and Freeport-McMoRan's price-to-sales multiples. Sterlite Industries shares are valued at a low 7.96 price-to-earnings ratio and a low 0.69 price-to-book multiple, both of which are cheaper than the price multiples of the S&P.

The 2.00% dividend yield of the stock is comparable to the 10-year treasury yield. Future dividend payments are likely because the company pays out 0.38 of earnings as dividends, so earnings could drop considerably before dividends must be cut.

Why Chase Commodities?

Rather than speculate on commodity markets, it is more prudent to sidestep these issues altogether. Some blue-chip tech stocks are trading at more attractive price multiples than copper miners.

Apple (NASDAQ: AAPL) trading around $577 per share presents a growth-at-reasonable-price opportunity. Investors can buy more revenues per dollar from the S&P 500 since this index has a price-to-sales ratio of 1.32 while this stock has a much higher 3.58 ratio. Apple shares are trading at a fair 13.06 price-to-earnings ratio, in line with the S&P 500 average.

At around $22 per share, Intel (NASDAQ: INTC) is a better income investment than Freeport-McMoRan. This stock pays a hefty 4.23% dividend which is more than twice the 1.82% 10-year treasury yield. Future dividend payments are likely because the company pays out 0.34 of earnings as dividends, so earnings could drop considerably before dividends must be cut. The firm does not have a weak balance sheet and carries a reasonable 0.15 debt-to-equity ratio, demonstrating that the firm is not overleveraged.

Intel is also trading at appropriate price multiples given its future outlook. Intel Corporation shares are valued at a compelling 9.62 price-to-earnings ratio, a value which is significantly lower than the 14.23 average of the S&P 500. The firm's 2.07 price-to-sales ratio is higher than many firms, but is acceptable for a tech firm with high margins. It's higher price-to-sales multiple does not detract from its compelling price-to-earnings multiple.

No Crystal Ball Needed

Do I believe I can predict the centrally-planned decisions of PRC leaders or the free market price swings in commodity markets? No, and I doubt you can either. Fortunately, the price multiples of copper miner Sterlite are low enough that they are appropriate for a commodity firm, even for us non-psychics. On the other hand, shares of Southern Copper and Freeport-McMoRan trade at valuations that are just too high for commodity producers. Investors would be better served by investing in Apple or Intel instead. These tech firms provide differentiated products and do not compete solely on price as commodity producers do. They are also less exposed to top-down political decisions in the People's Republic of China.

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BillEdson11 has no positions in the stocks mentioned above. The Motley Fool owns shares of Apple, Freeport-McMoRan Copper & Gold, and Intel. Motley Fool newsletter services recommend Apple and Intel. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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