Why I Would Buy FCX, VALE
David is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As concerns loom over sovereign debt issues (that have not been resolved!), it is inevitable, in my view, that greater interest will rise in mining stocks. Two producers that attract me in the sector are Freeport McMoRan (NYSE: FCX) and Vale (NYSE: VALE). While Freeport has been overly discounted from poor labor recessions in the recent past, it still has excellent fundamentals and projects that are starting to ramp up. Vale, similarly, has been overly beaten down from an uncertain market. I recommend buying equity in both companies.
Freeport is close to a pure copper producer although it is diversified in gold at Grasberg (where the notorious strike took place). Low ore grades and volumes at Grasberg have also been disappointing, but investors are not considering the fact that management has a production timeline. 2015, not 2012, will be the year when Grasberg hits production around 2009 levels. But the market is being myopic and prefers to look at the short-term cycles, which can be inherently volatile - especially in today's macroeconomic climate.
The secular trends, however, all point upwards. Chinese demand will rise and keep copper prices high and will prevent supply inelasticity from compromising market supply as many investors fear. All in all, after acquiring Phelps-Dodge to secure North American, African, and South American positions, Freeport is the market leader and thus is more of a price maker than a price taker. It sells roughly 4 billion lbs of copper each year.
With market power also comes, whether you like it or not, political power. Many investors are fearing resource nationalization in Indonesia. In my belief, this is not at all an issue, since the government is not out to destroy business. Perhaps they may use it to their own corrupt benefit but they don't want to drive out potential gains. Accordingly, I recommend buying now to capitalize off of the inevitable rise in gold output when fear dissipates over the business environment. In addition, the rise of emerging economies will keep prices elevated and prevent them from returning to the $1 level that we have seen in recent decades.
Perhaps the best way to look for undervalued stocks is to compare companies to peers. If the fundamentals are good but the multiples lag for no apparent reason, there is room for the value gap to be closed. Southern Copper (NYSE: SCCO) is currently priced at 14.6x forward earnings with a generous 4.6% dividend yield. Liquidity is strong with the quick ratio nearly at 3.5x. Despite a large economic moat, Freeport is selling cheaper. Analysts recognize this value gap and thus give Freeport's stock a "strong buy" on the Street. BHP Billiton (NYSE: BHP), however, is cheap at 11.2x forward earnings and a 3.2% dividend yield. Analysts are forecasted around 100 bps greater annual EPS growth for BHP over Southern, so I recommend buying the former as the market begins to close the difference in multiples. BHP is just about as cheap as Freeport but is an even larger company with a long operating history. Accordingly, I recommend buying shares in both firms: Freeport for the growth and value; BHP for the safety and value.
Vale is also a strong bet on the long-term macro picture. 2Q12 was under pressure with the company reporting only $5.5 billion in EBITDA versus a forecast for $6.3 billion. As EPS revise downwards at a time when iron ore prices are expected to decline, investors will naturally eye an exit. However, margins have been increasing from the dilution of fixed costs and reduction in capital expenditures. During the first half of this year, slightly more than three-quarters of capital expenditures went towards growth projects. That is more than enough to secure strong momentum during this uncertain economy. As free cash flow picks up, it can then hike up spending during a recovery to capitalize on the excitement and industrial activity. The firm has a strong line of projects that will ramp up and this will drive up the free cash flow yield from 6.9% in 2015. Net debt is concerning and forecasted to rise from around $20 billion in 2011 to possibly $30.1 billion, but this leverage is being used to secure large market power. In the long-run, this will pay off as Vale will better be able to secure prices and attractive contracts.
TakeoverAnalyst has no positions in the stocks mentioned above. 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.If you have questions about this post or the Fool’s blog network, click here for information.
