I'm Adding This Mining Stock to My $100,000 Real-Money Portfolio


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In most instances, it pays to focus your investment research on companies that are delivering great results. Rising profits, thanks tomarket share gains, hot new products, international expansion and other factors often lead to a surging valuation for a company.

Yet for some types of stocks, this logic gets turned on its head. It's more important to see how a stock will be valued when business conditions are not quite so favorable. If theincome statement takes a turn for the worse, then a large contingent of investors will likely head for the exits, revealing the price level in which more far-sighted investorsspot deep value.

This has been my thinking since I have had a chance to digest the quarterly results of copper and gold miner Freeport McMoran ( FCX ) . A host of factors has just led year-over-year profits to fall sharply, and it's increasingly clear that investors are misreading many of the fundamental factors that should drive the company's results -- and valuations -- in the quarters and years to come.

It's why I can't resist the opportunity to add this global mining powerhouse to my $100,000 Real-Money Portfolio , as it possesses the two key characteristics I look for: robust potential upside and solid downside protection.

Focus on the assets for now
I have actually written about Freeport McMoran twice recently. First, I noted how investors had been selling the stock as profits slumped, missing the fact that the company's copper and gold mines are actually worth much more than the current stockmarket value would suggest.

Unfortunately, you won't find this value on the company'sbalance sheet . Indeed the company's $36 billionmarket value is well higher than its $16 billion in shareholder's equity. But this figure is quite misleading. It represents what Freeport McMoran has paid for various mines in the past - not what those mines are worth today. 

Thankfully, we can grasp what mines are really worth. They are bought and sold every year, and we have a clear read on what companies pay to acquire various mines. This is where the work ofWall Street analysts can come in handy. Analysts who follow Freeport McMoran continually track the global mining industry and then seek to adjust the relative value of every company's mining assets -- if they were valued in line with recent deal trends.

For example, as I noted last week, Goldman Sachs says Freeport McMoran would be worth $50 a share if investors used current industry transaction trends as abenchmark . Of course, this assumes that a potential buyer would look to acquire the company at value accorded to other mining firms that have recently sold off assets.

This seeming undervaluation was one of the reasons why industry chatter suggested potential buyers were circlingoverhead , which I discussed here . I cautioned that many rumored deals never come to pass, and in the face of such chatter,  Freeport McMoran'sCEO Richard Adkerson went on CNBC this week to try to cool down the buzz, noting the company wasn't for sale.

But then he inadvertently expressed the precise reason I really appreciate this stock. "Natural resources are short. Companies in our industry have strong balance sheets and strong cash flows. Trying to find new deposits is a challenge. We have great assets," he said.

Let's look at what this means for the coming five years (and why I think this stock will solidly appreciate a lot more quickly than that). The globaleconomy rises and sinks every few years, taking demand for copper, gold (and molybdenum, which  Freeport McMoran also mines) up and down. But if you widen the lens, then you see that long-term demand tends to move on a more direct path -- upward. Let's look at copper in particular, which is used in residential and commercial construction, power lines, health care and a wide range of technology devices.

The chart above highlights a steady upward move, but there have been times where it appears as if global copper demand has finally reached a peak. After World War II, demand slumped as global defense spending on new equipment pulled back. Demand slumped in the 1970s as global economies skidded intorecession . It happened again in 2001 and again in 2009. Even if you assume that growth won't rise at the steady pace this chart suggests, then it's pretty clear that the globaleconomy will be consuming more copper in the years to come -- not less.

And asCEO Adkerson notes, there is a finite amount of copper that is readily mined. Simply put, the supply and demand picture enables this company to generate decent profits when the global economy is under pressure and copper demand cools, and really solid profits when demand is at a more normal state (which I'll discuss in a moment).

Yet if you just looked at  Freeport McMoran's just-announced first-quarter profits, you'd hardlycall the results "decent." Work slowdowns at the company's Grasberg copper and gold mine in Indonesia (which incidentally holds the largest repository of copper in the world) led to sharply curtailed output. Management and labor haven't made peace yet, but continue to talk and have made major progress. And daily output, which had fallen by half on many days, is now back near normal levels. Yet the damage was done. First-quarter net profits fell by half to $764 million ($0.80 a share).

What does thismean for the future? Well, management's concessions to labor now means that a typical pound of copper derives a little more than $2 inprofit (using the Grasberg mine as an example), compared with $2.50 a pound in previous labor costs were in place. Rising labor costs are surely an issue for mining firms across the globe, but not the absoluteprofit killer that some might think.

Lastly, this stock had been under pressure for another reason beyond labor concerns. The Indonesian government has revised the laws governing foreign ownership of domestic assets. Management put this concern to bed this week, noting that after talks with the Indonesian government, it was decided that previous agreements supersede the new laws, so Freeport McMoran isn't at risk of having its mines appropriated by the government. Still, the company aims to make some sort of concession, perhaps giving up 10% of its mining stakes in Indonesia.

[block:block=16]The road ahead
When it comes to copper and gold prices, there's no crystal ball that will underpin profits -- and the stock price -- for  Freeport McMoran. But we know that copper demand remains above copper supply, according to several industry forecasts and, barring a major economic slowdown in China, that should be the case in 2013 again as the U.S. and European economies trend a bit higher than current levels. That's why Freeport McMoran aims to boost output of copper and gold by roughly 25% during the next three to four years.  This sets a backdrop for steadily improving results, with the just-released first quarter likely representing the last weak quarter for this company for some time to come.

The Downside Protection --> The economic crisis of a few years ago pushed this stock down deeply as the global economy threatened to tumble into the abyss. A repeat of this kind of event is extremely unlikely, andshares have otherwise never slipped below $30 at any point in the past five years. This can be seen as an absolute floor for this stock. Shares currently trade about $38, and any slippage into the mid to lower $30's would bring out a fresh wave of buying support as long-term investors start to focus on the value of Freeport McMoran's copper and gold mines.

Upside Triggers --> Copper and gold prices are an obvious determinant of the direction of this stock -- with a heavy emphasis on copper. Thanks to the current supplydeficit for copper, most analysts expect copper prices to finish 2012 at about $3.80 a pound and stay there in 2013, which is slightly above current levels.

If you exclude the recent challenges in Indonesia, then this is a company that typically earns roughly $5 a share, meaning shares trade for around 7.5 times profits. Shares also trade for less than five timesEBITDA , on anenterprise value basis. That valuation assumes copper in the $3.75 a pound range.

Looked at another way, this is a company that generated nearly $4 billion infree cash flow on two occasions in the past five years, (and close to $2.5 billion infree cash flow in two other years in the period). But rising production output figures to boost those numbers to fresh peaks, even with slightly higher labor costs. That's why free cash flow could approach a record $5 billion by mid-decade (after a current spike in capital spending winds down). With a currententerprise value of around $35 billion, shares sport a projected free cash flowyield in excess of 10%, perhaps approaching 15% in coming years. The combination of undervalued mines and tremendous free cash flow out of those mines, are the main pillars of value in this currently out-of-favor stock.

To be sure, this has the potential to be a trade more than an investment. If the stars re-align, and shares move back into the mid-$50's -- where they stood last summer -- then investors should book profits. FCX will always gyrate wildly, and the key is to latch onto this stock when it's out of favor.

Action to Take --> Two days after you read this, I will buy 200shares (or roughly $7,600 worth). I also suggest investors put in astop loss at $34, though as I recently noted, I will not be deploying the stop-loss limits myself.Shares can be bought under $42.

-- David Sterman

David Sterman does not personally hold positions in any securities mentioned in this article. StreetAuthority LLC does not hold positions in any securities mentioned in this article.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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This article appears in: Investing , Commodities

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