Investors have been fretting about a weaker
economy
and the implications for economically-sensitive assets such as
steel, copper, iron ore and other commodities. Indeed, the
underlying
spot
prices for several key commodities are at multi-year lows and stock
prices of commodity-sensitive companies have also been quite
weak.
Yet I continue to think such a backdrop spells
opportunity.
That's why I added
Alcoa (NYSE:
AA
)
to my
$100,000 Real-Money Portfolio
at
the start of the year
, and
then added
copper and gold producer
Freeport-McMoran (NYSE:
FCX
)
to the portfolio in April 2012.
Did I think these stocks were poised for an imminent rally? No.
I only believed they represented the chance for great multi-year
gains and, equally important, likely carried a solid degree of
downside protection. How has this view played out?
Even as the global economic outlook has weakened considerably since
the start of the year, this economically-sensitive stock has fallen
less than 10%. Crucially, with this stock price near tangible
book value
(of about $8.25 a share) I don't see a lot more downside. I'll take
that. And though I doubt
shares
will hit the $40 mark anytime soon (which is where they traded back
in 2007), a move to $15, $20 or even $25 looks to be in the cards
in a year or two. This kind of positioning is in keeping with my
portfolio strategy: "Look for stocks with limited downside but
potentially long-term upside."
What about Freeport-McMoran? Since I added this stock to my
portfolio in late April, copper prices have fallen from roughly
$3.65 a pound to a recent $3.35. Shares have fallen from $37 to $32
since then, which I'm not happy about, but also see as a small
downward move in the context of a potentially more robust long-term
gain.
Completely different drivers
Though both of these commodity-sensitive stocks are surely affected
by the current scary economic picture in Europe, the factors that
will help determine future performance are quite
different.
For Alcoa, a rebound could only come when global aluminum demand
exceeds supply. I recommended this stock in January precisely
because the Chinese government was signaling plans to curtail
domestic aluminum output, as the manufacturing process is very
energy-intensive. Alcoa, which has the lowest-cost smelters in the
world, stood a chance to greatly benefit from supply reductions by
rivals.
The company even showed its own industry leadership by
announcing capacity cuts back in February. Trouble is, China never
followed through on its promise, so supply has not been cut to the
extent that I had expected. Yet it's crucial to note that Alcoa is
currently operating at break-even in the context of current spot
aluminum prices (of about 82 cents per pound), while major rivals
are operating at a loss, due to their higher-cost smelters. As a
result, I still expect to see industry capacity cuts in coming
quarters and eventually a solid rebound in demand. When that
happens, this stock will likely go considerably higher, perhaps
100% of 150% above current levels.
The global picture for Freeport McMoran differs. The copper
market
is actually quite undersupplied right now and key copper
inventories are dropping. The fact that copper prices -- and this
stock -- are falling is solely due to fears of an ever-deeper
economic slowdown.
Yet even a drop in demand may still keep this market
undersupplied, so copper prices should stage a solid rally when
commodity
traders come to see that a copper glut has not emerged. That should
light a fire under this stock, though I caution that it may not
come before 2013. And this stock could slip into the upper $20s
before any such rally kicks in.
A shared virtue
The key appeal for these two stocks is the nature of their assets.
Alcoa operates the world's most advanced network of aluminum
smelters and a set of appealing
downstream
businesses as well. Freeport-McMoran owns some of the most
productive copper mines in the world, and notably, geologists
believe we'll be past the peak point of supply for copper within a
few years as the world's most productive copper mines start to play
out. So Alcoa and Freeport-McMoran are sitting on a world-class set
of assets, which again, provides support to shares in scary
economic times.
Risks to Consider:
Though Alcoa appears to have solid support in the current
$8.25-8.75 range, Freeport-McMoran is a bit more volatile and, as
noted earlier, could move another 10% to 15% lower from here before
any eventual rebound.
Action to Take -->
On these companies' upcoming quarterly conference calls, listen
closely for discussions of industry supply and demand. Alcoa has
deep insights into global supply trends, so management's commentary
will likely set the tone for the rest of the year. Freeport-McMoran
is likely to continue to highlight the fact that copper demand
still exceeds supply, even as the global economy stinks.
I don't anticipate either of these companies delivering
second-quarter results that will ignite shares. Instead, it will be
the broad investor sense that the European crisis has (at least
temporarily) been contained. Or it may be the expectation that the
new round of Chinese economic stimulus will bolster commodity
prices. In a nutshell, the backdrop for these stocks is simply
lousy right now, which is why I find them so appealing. You only
make money in commodity stocks when they are deeply out of
favor.
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-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC owns
shares of FCX, AA in one or more if its "real money"
portfolios.