Editor's Choice

Two Buy and Hold Commodity Stocks

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

Do you favor the long-term outlook for commodities, but feel that timing the cycles is futile?  Do you want to buy and hold a few stocks that are levered to commodity prices in the anticipation that they will outperform over the next decade?  For investors that are in such a situation, I have two stocks that merit attention today. Not only that, but these two stocks are diversified and shouldn’t get crushed during bear market pullbacks. Their volatility should be less than peers, albeit still higher than the average stock in the S&P 500. In a nutshell, these two stocks are great buy and hold candidates in the commodity space.

The energy play

Apache Corporation (NYSE: APA) is an independent energy company that owns a balanced portfolio of oil and gas properties.  The company has assets in the United States, Canada, Egypt, Australia, the North Sea, and Argentina. The company’s reserve base is 56% gas, 39% crude and 5% natural gas liquids. They are deemed a mid-major with revenues of $16 billion and a market capitalization of $40 billion.

The company stands out for its diversity and consistent operating performance. They operate in six countries and no region accounts for more than 30% of production. Not only that, but they have a good split of oil and gas that provides stability when prices decouple, as is the case today with oil above $100 per barrel and natural gas prices depressed. Apache has grown production in 30 of the last 32 years mostly through an acquire-and-exploit strategy. Production growth is one of the highest in the industry and has averaged a CAGR of 11% since 1995. They opportunistically make acquisitions and they did that again recently by adding $16 billion worth of deals in the previous two years. They are possibly the best in the industry at taking assets from peers and increasing production well beyond current trend levels.

Egypt is the largest source of production at 22% and served as the catalyst for 20% underperformance versus peers in 2011. We agree with other third-party sources that the fiscal regime in the post-Mubarak transition will not produce any significant changes to the oil and gas infrastructure. Other key risks for the company are the dependence on commodity prices, reserve replacement, and potential government regulations. 

It can be difficult to value a cyclical company using traditional analysis because of distortions at both the peaks and the troughs. In fact, when earnings are low and the P/E high, it is generally the best time to buy. Sometimes it makes sense to utilize the cyclically-adjusted P/E (CAPE) for these particular instances.  This is easy to accomplish, just divide the average earnings over the last ten years by the current stock price.  Apache has averaged $7.21 in earnings-per-share over the last ten years and equates to a CAPE of 15x.  Try finding any other stock in the S&P 500 that has a CAPE of 15x.  There are some, but not many and it is an indication of how cheap the stock is.  Of course, the last ten years has been a commodity boom, so it is NOT a true full-cycle picture because each of the troughs was higher than the previous one.  Still, it is a more useful tool than a static price-to-earnings analysis. 

Apache stands out because of its diversity.  You may have been waiting for natural gas prices and oil to return to their historical relationships, but the divergence is lasting longer than expected.  Henry Hub natural gas prices are around $2.25 per MMBtu compared to $5 a year ago and $13 in 2008!  The supply of shale gas is suppressing the price to the point that some companies find it cheaper to just burn excess gas than transport it for sale. 

Encana (NYSE: ECA) is a high quality E&P peer that operates in North and South America. The company generates annual revenues of more than $11 billion, but 80% of that is natural gas. The stock is down 44% from its 2011 high and more than 75% from its 2008 peak. It is very difficult to time when natural gas prices will finally bottom. An alternative would be to buy Apache, which gives you exposure to both oil and gas, but doesn’t make a significant bet on either one. 

The metal play

BHP Billiton (NYSE: BBL) is the world’s largest and most diversified natural resources company.  The company was formed from the mega merger of BHP and Billiton in 2001.  Prior to that, Billiton traces its roots back to Indonesia and was founded in 1860.  BHP stands for Broken Hill Proprietary and was founded in 1885 on the mainland of Australia.

BBL’s strength lies in its superior scale and diversification.  Annual revenues exceed $70 billion and covers resources from iron ore to diamonds.  Iron Ore is the largest segment and because of its higher margins contributes about 37% to total EBITDA (operating earnings).  The remaining key segments are Petroleum (22%), Base Metals (20%), and Coal (11%).  Aluminum, Diamonds, Steel, and Manganese make up a small portion of earnings.

Two important things that allow BHP Billiton to stand out against the crowd is their superior ROIC (return on invested capital) numbers and top-notch management.  ROIC is consistently in the 20-40% range and was even 18% in the depths of the Global Financial Crisis.  These numbers are well above the company’s cost of capital and are a sign of great operational performance.  The second, and partly related, is that management will reduce capital expenditures in 2012 and 2013 if need be to prevent inventory builds.  This allows the prices to stay elevated and provides additional capital for dividend payments and share repurchases.  Management is also willing to divest assets that are not contributing to earnings as a way of maximizing returns on invested capital.  They are NOT just trying to get big and the ROIC numbers bear that out.

The valuation on this stock is pretty attractive by any measure.  The price-to-earnings ratio is only 8x, one of the lowest levels ever for this stock.  Not only that, but the stock trades at just 12x the average earnings over the last five years- which happened to include the biggest recession in eighty years.  12x mid-cycle earnings is especially cheap in the context of a 3.3% dividend yield that has grown at a 32% 5-year average annual rate. 

BHP Billiton Plc makes more sense as a buy and hold name than iron ore peers, Cliffs Natural Resources (NYSE: CLF) or Vale (NYSE: VALE).  Cliffs is the largest producer of iron ore pellets in North America.  The company’s profits are almost entirely sourced from iron ore and it is now essentially a play on China given that they account for nearly 60% of worldwide iron ore imports.  Cliffs has tremendous upside, but also has tremendous volatility.  The stock lost more than 90% of its value during The Great Recession and has gyrated significantly with the mood of the market.  This stock is more of a bet and not a great buy and hold name. 

The same story is true of the Brazilian giant Vale.  The company is the world’s largest producer of iron ore.  They are more diversified and much larger than Cliffs, but still derive more than 70% of revenues from iron ore related products.  Vale’s stock price will be significantly impacted by the economic outlook in China, specifically Chinese imports.  This stock has the size and is a popular holding among investors that favor material stocks, but still looks to fall short as a quality buy and hold investment.

Bottom line

Apache and BHP Billiton are two stocks that make sense as buy and hold stocks for investors that like the secular outlook on commodities.  These two stocks should provide less downside volatility due to their diversity.  Timing is everything with commodities and it isn’t easy to get right.  For most investors, it might make sense to buy the stocks best capable of smoothing the wild ride that is commodity prices.

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