A Bet on Chinese Growth and the Global Recovery

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

A few years ago I had some cash that I wanted to invest.  I wasn’t too thrilled with the returns of my mutual funds, so I decided to purchase a few stocks.  Because I had the prospectus in my hand, I decided to use that as a screen.  I took a glance at the top 20 or so holdings of my emerging markets mutual fund and then compared that list of stocks with the top 20 holdings of other similar mutual funds. 

In this exercise I came across a stock that appeared as though it was getting noticed by some of the emerging markets mutual funds but not others – probably because at that point in time the company was not a household name with experienced investors like it is today.   Long story short, after doing some research on the company I decided to purchase its stock.

That company was Vale (NYSE: VALE) a Brazilian metals and mining company.  Vale was attractive because of its exposure to emerging markets, valuation, and potential for growth.

Now I am taking another look at Vale because of a few articles that I recently read about Chinese growth, the global recovery, and Vale’s capital expenditures.  Fortunately I was able to listen in on a presentation that Vale gave to analysts and investors at a recent conference in New York City – my take on that presentation is below. 

The Case for China

As you would expect, the presentation started with the “China story.”  The presentation started by comparing China’s per capita GDP to other countries such as Japan and Korea and Taiwan.  The takeaway of the first few minutes of the presentation was that Chinese demand for steel will not peak for at least another decade.

The first piece of evidence used to support this claim was research done on Asian economies that suggested that demand for steel tends to peak when per capita GDP is between $15,000 and $20,000 (China’s per capita GDP is around $8,000).    

The second piece of evidence was research that forecasted that the urbanization of China will continue for at least the next 15 – 20 years and that over that time period China will see its urban population expand from 300 million to more than 1 billion. 

The inference was that China will build many high-rise buildings that resemble those built in densely populated Asian cities in order to accommodate massive urbanization, which will increase demand for Vale’s products.     

The third piece of evidence was research that concluded that China “will have a rising share of multistory apartment blocks with much higher steel consumption per square meter,” which will also result in demand for Vale’s products and services.

The presentation then explained how China will need steel to meet other infrastructure needs and to build things like cars as well as to upgrade existing poor housing.  If you compare China to the United States or the European Union, for instance, China has 36 cars for every 1000 people whereas both the United States and the European Union have more than 450 cars for every 1000 people.    

Then the presentation addressed the threat of scrap as an alternative to iron ore.  The presentation made two points: the infrastructure is not in place to support scrap supply and substitution is limited by technical factors.

The Lower Price Environment

The next critical takeaway was that the decline in the price of iron ore has resulted in shutdowns and a loss of iron ore capacity.  That apparently had a very material effect on producers in countries like Australia and the UK.

In fact, Australia has 2 large companies that compete with Vale that were significantly impacted: Rio Tinto and BHP Billiton.  Of the two companies, Rio Tinto (NYSE: RIO) provides a more interesting comparison. 

Compared to Rio Tinto, Vale not only trades at a significantly lower Price to Earnings Ratio (4.6 vs. 18.3), but also has a better cost structure and is better positioned to benefit from China’s growth. When we compare Vale’s Net Profit Margin of 24.53% to Rio Tinto’s Net Profit Margin of 8.45%, for example, Vale’s competitive advantage is very noticeable.

That advantage is also apparent when we compare Vale’s return on equity of 16% (which should improve in the future) to Rio Tinto’s return on equity of 7%, or Vale’s income per employee of $179,690 to Rio Tinto’s income per employee of $70,646. 

Overall, it appears as though Vale has a very competitive cost structure and has initiated several acquisitions and projects that will improve its supply chain and distribution.  Vale’s distribution centers in Oman and Teluk Rubiah, for example, minimize time to market and enable flexibility.

Capital Expenditure Concerns

The presentation explained that Vale will ensure that capital expenditures are in line with cash flows and that Vale wants to maintain its investment-grade rating. 

Vale stated that organic growth is a priority for all of its projects.  Vale also stated that it will divest assets that are not providing adequate returns and that it will continue to explore partnerships that create value.     

I was not particularly convinced that many projects were generating high returns and creating shareholder value.  Nor was I very convinced that many of these projects were well executed. 

Overall, improving project selection criteria and execution are very large areas of opportunity for Vale.  That said, Vale does have a fairly impressive infrastructure and appears poised to garner a larger share of the market.     

The Catalysts

The most obvious catalyst that will likely propel VALE’s stock price higher is that it appears as though Chinese growth is accelerating.  Today I picked up the Investor’s Business Daily and on the front page read “Q4 output expanded 7.9% vs. a year earlier, ending a 7-quarter streak of deceleration and confirming the No. 2 economy is rebounding from a slowdown … Separate Dec. data showed industrial output climbed 10.3% annually, up from 10.1% in Nov.  Retail sales growth picked up 15.2%.”

In addition to growth in China, Vale will benefit from growth in Brazil.  Like China, Brazil implemented stimulus programs and new fiscal monetary policies that should spur growth.  Vale will also benefit from the 2014 World Cup and 2016 Olympics being held in Brazil. 

3 Reasons to Buy Vale

  1. Vale has a very attractive valuation, particularly if you consider its potential for growth.     
  2. Vale is focusing more and more on ensuring profitable growth and that it can rapidly react to both changes in price and volatility in demand.
  3. Vale will benefit from rising iron ore prices.   

My Foolish Take

There are several factors that make a compelling case to consider purchasing Vale such as Vale’s attractive valuation, exposure to emerging markets, cost advantages over its competitors, catalysts that will increase demand, rising iron ore prices – and an attractive entry point.  After all, at under $20 a share Vale looks very attractive.  I could very easily see Vale’s share price rising 30 – 50% or more over the next few years on either a global recovery or China growth.

RyanPeckyno is long Vale. The Motley Fool has no position in any of the stocks mentioned. 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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