Why I Have a Plan B for Copper
01/24/2011 4:44 pm EST
What if you’re wrong? Always a possibility worth contemplating.
Last week (January 20 and 21), I gave you a pretty pessimistic view of the prospects for the world’s emerging stock markets—and emerging-economy-dependent stocks such as those of commodity producers—over the next six months. The fight to control inflation in these economies will require repeated interest-rate increases that will slow economic growth. That will result in a correction of about 20%, I concluded.
If that were a dead certainty, we’d all know what to do right now. Sell all your emerging market stocks and all the shares you own of commodities and materials companies.
But very little is a certainty in investing. US economic growth could pick up quickly and strongly enough so that increased demand from the United States balances out lower demand from China and the rest of the emerging-economy gang. Inflation in China could succumb to measures short of repeated interest-rate increases when a bountiful summer vegetable harvest crushes food inflation like an overripe tomato.
The scenario I laid out in my inflation-fighting posts is the most likely, in my opinion, over the next six months, but there’s still a non-trivial chance that it could be wrong.
This is where I remind you that your goal right now is to find a strategy that minimizes two potential costs.
First, there’s the cost of a market correction—if I’m right. I’ve noted that it’s important to remember that a 20% market correction is only a 20% average drop. Some stocks will get hit much worse and others much more. You’d like to avoid the 20% drop, of course, but even more, you want to avoid owning stocks that will take a bigger-than-average hit. Hence my advice to cull second and third-tier stocks and markets from your portfolio.
Second, there’s opportunity cost—if I’m wrong. If instead of dropping 20%, emerging markets go up 20%, you’d like to capture some of that gain instead of missing it all.
So how do you strike the best balance on these two kinds of potential costs? Let me use copper miner Freeport McMoRan Copper & Gold (NYSE: FCX) as an example.
If I’m wrong and either emerging markets do better than I now expect or US growth is stronger than I expect (so the US economy picks up part of the slack,) copper will be one of the big beneficiaries. Right now, the predictions calling for a slowdown in demand growth for copper in 2011 are still calling for 6% to 8% growth. That’s only a slowdown compared to the 10% growth of 2010.
And that level of demand growth would probably be enough to keep copper prices climbing in 2011, given the problems that copper producers are having in increasing supply even with copper at near-historic high prices.
On January 20, in the guidance for 2011 that went with its release of its 2010 financial report, Freeport-McMoRan said that 2011 copper and gold sales would be slightly below earlier forecasts. The drop isn’t large—from a forecast of 3.9 billion pounds of copper back in November to 3.85 billion in yesterday’s guidance—but the reason for the decline is hugely important. The company will produce less copper and gold from its Grasberg mine in Indonesia because of a decline in the grade of ores being mined. This problem—lower-quality ores that require a mining company to move more earth to get the same amount of copper—isn’t limited to Freeport McMoRan. It’s a problem across the industry: The quality of ores in the copper mining industry’s big existing mines is falling. Copper miner Rio Tinto (NYSE: RIO) this week announced that it had mined 16% less copper in 2010 than in 2009.
Big new mines that may solve this problem—if ore grades there are high enough—are scheduled to start coming on line in 2013, but until then, copper supply will have a tough time meeting copper demand if there’s any growth in demand at all.
You can see the power of that dynamic in the results that Freeport McMoRan announced on January 20. Net income for the fourth quarter of 2010 climbed by 60% to a record $1.55 billion, or $3.25 a share, from $971 million, or $2.15 a share, in the fourth quarter of 2009. Earnings per share for all of 2010 climbed to $9.14 from $5.86 in 2010. Right now, Wall Street thinks earnings per share will climb another 32% to $11.70 a share in 2011. (Remember, these projections could well be wrong.)
I’d prefer not to miss that earnings story—if it comes true.
So how do you get your head around the cost of a correction and the cost of missing an opportunity?
I do it by looking for the most attractive way to participate in the upside story that comes with the least downside risk.
I’d argue that for copper, I maximize my potential gain and minimize my potential loss by owning Freeport McMoRan. After yesterday’s earnings report, the stock trades at just 12.1 times 2010 earnings per share and at just 9.5 times projected 2011 earnings per share. That’s cheap for a stock with Freeport’s potential earnings growth.
And Freeport isn’t risking a lot of new capital to increase production. I laid out this case in more detail in my initial buy recommendation. Freeport’s capital budget for 2011 is a modest $2.3 billion. (Well, modest for a copper miner. Rio Tinto, in contrast, has a capital budget of $11 billion in 2011.) Because Freeport can expand production by 500 million pounds of copper in 2011 and 2012 through pit expansions, the company is relatively unexposed to the risk of copper prices stagnating. It doesn’t have all that invested capital on the line.
That subtracts from your risk in owning this stock in a very concrete way. Instead of sinking all those billions into new holes in the ground, Freeport McMoRan can return some directly to shareholders. The company raised its dividend to $2 a share from $1.20 in October and paid out a $1 special dividend in December. Dividends have the effect of putting a bottom under shares in a correction. (Freeport is set to split its shares two for one on February 1, by the way.)
None of this says that shares of Freeport won’t fall hard if the slowdown in emerging economies is worse than I expect. But it does say that if I want to cut my exposure to the downside of copper and preserve some upside, my best bet is holding onto shares of Freeport McMoRan through the correction and selling shares of other, riskier copper producers—with the idea, of course, of buying some of them back later and cheaper.
As of January 24, I’m keeping my target price at $140 a share ($70 a share after the split) by September 2011.
Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. The mutual fund I manage, Jubak Global Equity Fund (JUBAX), may or may not now own positions in any stock mentioned in this post. The fund did own shares of Freeport McMoRan as of the end of December. For a full list of the stocks in the fund as of the end of December, see the fund’s portfolio here.