The Recent Rally in Chinese Stocks Bodes Well for this Hated Industry

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

As we start out 2013, things look pretty promising for equity markets.  The U.S. equity market remains significantly undervalued, housing is firming, and the start of the great rotation out of bonds may soon be getting under way.  While the U.S. remains well positioned for secular outperformance, this year may very well see strong cyclical rallies in both Europe and China.  Emerging markets finished 2012 with a return of 17% versus 16% for the S&P 500, but they outperformed by more than 5.5% in the fourth quarter alone.  This cyclical rally remains in its early innings and investors may very likely be compensated for taking on additional risk in 2013.  China remains front and center when discussing emerging markets and the MSCI Chinese Index has surged 26% from September lows.  Economic data in the region appears to be moving higher, lending rates and policy remain accommodative, and inflation is only 2% for a country growing more than 7% per year.  I remain skeptical on the long-term success of the country, but the evidence clearly favors at least a cyclical uptrend in the region. 

Investing in China is not an easy task.   The easiest way is probably via the iShares FTSE China 25 Index (NYSEMKT: FXI) which has strong liquidity and provides instant diversification.  Conversely, there are plenty of derivate plays with the most obvious choice being metals and mining- and for good reason.   China accounts for more than 40% of global consumption in Copper, Zinc, Nickel, and Aluminum.  Thus it is no surprise that the Chinese market and commodity prices remain relatively correlated.  A resurgent China should lift base metal prices with a flow through into the equities of companies like Freeport-McMoRan Copper & Gold (NYSE: FCX) and Vale SA (NYSE: VALE).

The Popular Names Are Good Options

Freeport-McMoRan is the world’s largest publically traded copper company and the world’s largest producer of molybdenum.  They also generate about 10-20% of annual sales from gold.  The stock is attractively priced with a price-to-earnings ratio of 10x, a 3.6% dividend yield, and a price-to-book near historic lows. 

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Offsetting these favorable attributes is the company’s recent $20 billion spending spree for U.S. oil and gas assets.  Many analysts viewed the recent acquisitions as pricey.  Also, Freeport-McMoRan doesn’t have a lot of direct Chinese exposure, but rather ties its fortunes more directly to the price of copper.  At $3.63 per pound, the price has ticked up from 2012 lows but not substantially.  If Chinese growth can move copper back above the key $4 level then in all likelihood the shares would break out from their three-year funk.  The stock has appeal, but it may not be the best option as a derivative play on rising Chinese equities.

Brazilian-based Vale SA is the world’s largest producer of iron ore and generates annual sales of $50 billion.  While considered a diversified miner, the company ties its fortunes to the price of iron ore as the metal accounts for more than 70% of sales.  Vale has a more direct tie to Chinese growth than Freeport-McMoRan given direct sales to the region with iron ore being the key input for the steel making process.  Vale stock is attractive priced with a single-digit price-to-earnings ratio, and a trailing twelve month dividend yield of 5.6%, although dividend payouts fluctuate significantly from quarter to quarter.  The company also has a history of consistently generating returns of invested capital near 20%.  Vale, along with steel makers, are likely a more viable option than FCX.

The Hated Names Have The Most Upside

The real upside from a Chinese rally may well lie in one of the most hated industries- coal.  The chart below shows the strong correlation between the MSCI Chinese Index (white line) and a global basket of coal related equities (orange line).  Notice how the Chinese Index has a strong history of leading the movements in coal stocks. 


<img src="/media/images/user_36/coal_large.png" />

Global growth has allowed coal consumption to grow substantially despite a sharp downtick in the United States.  China is again of huge importance with nearly 50% of worldwide coal consumption!  Despite this huge number, there is room for continued growth.  According to Ned Davis Research, electricity consumption per capita in China is currently only one half that of Germany, one third that of South Korea, and one fourth that of the U.S.

Coal stocks have been shunned for the past two years and the valuation case is extremely compelling.  Peabody Energy (NYSE: BTU) is the largest domestically based coal company and the current quotation sits 65% below the stock’s 2011 high.  The chart below shows the relative price-to-earnings ratio against the S&P 500.  One can see that it sits at a ten-year low and substantially below any mean reverting trend line.

<img src="/media/images/user_36/btu_large.png" />

A similar case exists for other large-cap names such as Alpha Natural Resources and Arch Coal.  Getting diversity to the sector can be achieved via the Market Vectors Coal ETF (NYSEMKT: KOL).  This ETF has appeal in that the largest holding is Hong Kong listed.  It offers global diversity as well as individual credit diversity.  Offsetting these favorable attributes are periods when daily volume can fall below 100,000 shares.   Still, there appears to be just enough liquidity for the average investor. 

The Foolish Bottom Line

Chinese equities are poised for a big year in 2013.  Such a scenario will be a tailwind to metal and mining companies that have underperformed over the last two years.  The mega-cap diversified miners are a good option, but likely will underperform other potential high flyers such as steel and coal related plays.  Coal may have the best upside among all sub-industries thanks to excessively beaten down sentiment and valuation.  Everybody hates coal, which is exactly why you should be buying.

market8 has no position in any stocks mentioned. The Motley Fool owns shares of Freeport-McMoRan Copper & Gold. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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