Mining For Copper Stocks

Several smart analysts and money managers have pointed out that copper supplies continue to be tight and copper related stocks remain attractive.  Bill "The Casino Is Open" Fleckstein explains that tightness in all parts of the industrial economy has continued to increase the need for all base metals.  In Fleckstein’s most recent column he conveys a colleague’s sentiment about the base metals…

"The inescapable conclusion is that this whole damn system is stretched tight from top to bottom — all the past years of underinvestment are coming home to roost at once, and the situation is being exacerbated by the petrodollar boom. … We need more steel to build more equipment to dig more coal so we can feed new power stations, and use the extra energy to mine and refine more copper, which we need to wire new shipyards so we can launch more dredgers, so we can improve port facilities, so we can move more iron ore to the expanded railways, so we can make more steel. 

Yet, there is a downside to all this. Namely, that because of our diseased financial system, half the new production is based on zero (negative?) real cost of capital in China, and half the demand is based on credit, not income (whether at the household or the government level) in the West. If and when the wheels come off all this (are they in short supply, too?!), it is going to be truly horrendous!"

Copper is indeed an important industrial metal because it is used in wiring, motors, circuits, and corrosion-resistant alloys.  And despite the fact that copper related stocks have been one of the best performing groups behind energy, many copper stocks continue to remain attractively valued according to several earnings growth and value screens.   Investors are clearly betting that the price of copper will "revert back to the mean" and come crashing down.  That’s always a distinct possibility if a recession occurs in 2006.  However, given the strength of the world economy, it’s also a distinct possibility that copper simply corrects sideways before beginning another strong run.  Therefore, copper stocks remain interesting to me, even though I don’t own any right now.

The first screen which highlights copper stocks comes from master-value-screener John Dorfman.  He identifies Southern Copper (PCU) in his annual "bunny portfolio."  The screen finds stocks that had 25 percent compound annual earnings growth the past five years, and still sell for less than 12x earnings….

That can only happen when investors think the rapid earnings growth has ended, or is about to end.   From the eligible stocks, the program selects the five with the fastest historical five-year earnings growth rates, and the five with the lowest price-earnings (P/E) ratios. The union of those two sets is the 10-stock Bunny Portfolio.      

For the coming year, the five Bunny stocks with the lowest P/E ratios are Doral Financial Corp. (DRL), Overseas Shipholding Group Inc. (OSG), Ashland Inc. (ASH), Fremont General Corp. (FMT) and William Lyon Homes, which is back for a second year.

The five with the fastest historical earnings growth rates (excluding duplicates) are Valero Energy Corp. (VLO), Anadarko Petroleum Corp. (APC), Southern Copper Corp. (PCU), Tsakos Energy Navigation Ltd. (TNP) and Schnitzer Steel Industries Inc. (SCHN).

Second, the "Magic Formula" screen, developed by Joel Greenblatt of Gotham Capital, also shows Southern Copper (PCU) as a top investment choice.  Greenblatt’s screen searches for companies with high returns on capital and a high earnings yield, as explained in his book "The Little Book That Beats The Market".  I use a slightly different iteration of the screen which looks at estimated earnings instead of trailing earnings, and incorporates a debt/equity and free cash flow filter.  But the results are often very similar.  Here are the top 30 stocks based on my version of the screen and Southern Copper comes out on top…

Southern Copper screens out pretty well for several obvious reasons.  The company has enjoyed spectacular earnings growth and still trades at 6x earnings.  The fundamentals are strong and the company’s pedigree is also good.  The company is partially owned by Freeport-McMoran and Placer Dome.  In addition, the balance sheet is stellar. 

Market Cap: 9.86B
Enterprise Value (3-Jan-06)3: 10.48B
Trailing P/E : 5.58
Forward P/E (fye 31-Dec-06) 1: 8.48

Profitability 
Profit Margin (ttm): 37.17%
Operating Margin (ttm): 56.32%
Return on Assets (ttm): 23.78%
Return on Equity (ttm): 40.75%

Income Statement
Revenue (ttm): 2.59B
Revenue Per Share (ttm): 32.317
Qtrly Revenue Growth (yoy): 39.30%
Gross Profit (ttm): 1.03B
EBITDA (ttm): 1.59B
Net Income Avl to Common (ttm): 961.18M
Diluted EPS (ttm): 12.01
Qtrly Earnings Growth (yoy): 70.40%

Balance Sheet
Total Cash (mrq): 766.87M
Total Cash Per Share (mrq): 5.209
Total Debt (mrq): 1.23B
Total Debt/Equity (mrq): 0.384
Current Ratio (mrq): 2.673
Book Value Per Share (mrq): 21.653

Cash Flow Statement
Operating Cash Flow (ttm): 997.77M
Levered Free Cash Flow (ttm): 742.82M

Dividends & Splits
Forward Annual Dividend Rate: 6.37
Forward Annual Dividend Yield: 9.40%

However, now is probably not the right time to buy.  Copper has now had two parabolic runs in the past two years and betting that this parabola will continue is a low probability investment.    It seems to me that copper needs to break lower and form a sideways consolidation before it can be considered a "safe" investment. 

But even if the price of copper corrects, the stock could still work.  PCU gets tremendous leverage from high copper prices as the majority of the price increase flows to the bottom line.  Therefore, it can continue to support the current high dividend (10% by last measure) even if copper goes back to the $1.25 – $1.50 range.   Based on PCU’s chart, I would consider building a position in the high $50s.   

I would keep Southern Copper on my screen and wait for a more attractive opportunity to buy what has become an interesting cyclical growth company.