Stocks in highly cyclical industries have to be treated quite differently than other industries or sectors because of the cycles.
Portfolio management
I don’t mind leaving the party early
The topic today is selling a stock. Much of what I have written in the past about selling might be thought of as generalizations; as in, you should sell a stock immediately if you decide you made a mistake in buying it in the first place.
In this post I propose to talk about the specific sale of a specific stock at a specific time. We can think of it as something like the case studies used in schools.
A copper mining company
The company in question is First Quantum; FM on the Toronto stock exchange. It is a copper mining company. I first bought shares in the company more than five years ago at an average cost of about $15CAD. (Canadian dollars = CAD)
The reason this investment is interesting is that it is in a highly cyclical industry. Stocks in highly cyclical industries have to be treated quite differently than other industries or sectors because of the cycles. It is also interesting in that commodity companies have essentially no chance to develop what Warren Buffett calls a moat, that is, a business franchise that gives the company some scope to raise prices. Their lives are rules by commodity prices.
Warren Buffett tells us that his favorite holding period of a stock is “forever”. That advice doesn’t make any sense for mining companies and other highly cyclical industries.
In the spring of 2022 commodity prices are on a roll. This is especially true for copper mining companies. So why sell?
Why I bought it
To understand why I am selling it one needs to understand why I bought it. Let me go back a bit. In my investing career I’ve invested in well over one hundred companies. Until January of 2009 I had never invested in a mining company. I had always stuck to companies where I had the possibility of holding them forever; Warren Buffett type companies.
The Great Financial Crisis steamrollered everything, including mining companies. In January 2009 I found one so cheap that you got the mines for free plus got all the cash on the balance sheet for cents on the dollar. It was like finding a $20 bill lying on the ground. I did well, a bit like Warren Buffett’s cigar butts.
Later, in a spirit of diversifying to other countries around the world I came up with a Chinese company that was developing an iron ore mine in the Pilbara region of Western Australia. I did very poorly. I learned from this experience that one of the most critical things with investing in mining companies is the expertise of the company in developing mineral deposits into a fully operating mine.
In time I learned about First Quantum. When I first came upon the company it was run by its founders who had built it from an exploration and mine development company focused on Africa to a global copper producer with six producing mines in eight countries around the globe. It was in process of developing a massive copper mine in Panama. The analysts said that it had developed a well-deserved reputation for bringing in its mine development projects on time and on budget. It was clearly a superb mining company, but did I want to invest in such a cyclical industry?
My thinking was this: the company offered diversification for my portfolio. It offered a possible hedge against inflation. It was a really good company and run by the founders who had huge personal stakes in the common shares of the company.
On the downside, the copper segment of the mining industry was clearly cyclical. I would have to learn how to ride that specific rollercoaster. A forever holding period might not make sense.
What I’ve learned
In the mining industry there are two critical ideas to understand. The first is about spot prices and long term price estimates. The second is about Net Asset Values.
Spot prices are what copper is selling for today based on supply and demand. The current spot price is $4.72US per pound which is in the range of the highest price in years. But, the world is not running out of copper. Over the long term, the price of copper is closely related to how much it costs to mine a tonne of the stuff. If prices are high, more mines will be developed and prices will tend towards production cost plus some profit. I have read that the current estimated long term price of copper will tend towards $3.50US. Spot prices can be higher than this figure and can also be lower.
Analysts estimate the Net Asset Value of a mining company. To do so they need to model future funds from operations so they can do a discounted cash flow analysis. If too much weight is put on high current spot prices the estimated Net Asset Value will be too high. Over the years I have seen the stock price of mining companies trade at a discount to Net Asset Value and also trade at a premium.
Analysts also come up with target prices for mining company shares that are based on a variety of multiples. I don’t pay much attention to these target prices.
Let’s look at a chart
This chart is as of Friday’s close. It is clear that the stock price has been on a tear.
Back to reality
I look at the fair value estimates published by Morningstar. In late March 2021 Morningstar estimated the fair value of the shares of the company at $23.21 CAD. I keep track of these things. At the end of February 2022 Morningstar estimated fair value at $47.37 CAD. I couldn’t believe the fair value of the company had doubled in one year. Then last week they changed their fair value estimate to $38.99 CAD. I wondered what was going on.
My discount broker is RBC Direct Investing which is an arm of the Royal Bank of Canada, Canada’s largest bank. RBC also has a full sell side brokerage operation serving institutional investors. Their current price target is $43.00 CAD. But, their estimate of Net Asset Value is $31.08 CAD.
For a whole lot of reasons commodity prices are running hot. Copper spot prices are being swept along with the rest of the commodity run up. There is very little about the war in Ukraine that impacts copper. Russia supplies only a very small fraction of world copper demand. Copper is certainly enjoying the halo of being a commodity that will be used in electric vehicles. But, the world has lots of copper.
My thinking
I really don’t think the fair value of the company has doubled in the last year. I suspect the company will trade at a discount to its Net Asset Value sometime in the next five years. It’s entirely possible the stock will trade up over $50 CAD per share but, so what.
I don’t mind leaving the party early. Being in a highly cyclical industry, this is not a company to hold forever.
Two years ago First Quantum was, for a time, my largest holding at over 12% of the portfolio. I sold some just to avoid too much concentration and idiosyncratic risk. A year ago it represented about 8% of the portfolio. By early tomorrow morning I will have sold my entire holding. I’m looking at a beaten down financial technology stock to invest in. But that’s a story for another day about a proper buying process.
Conclusion
I thought it might be instructive for readers to understand some of the thought processes around selling. The ‘case study’ about First Quantum is happening in real time. Readers will be able to connect up what I have written with what they understand is happening in the economy today.
Investments in commodity companies and other highly cyclical companies have to be dealt with differently from companies you would hope to hold forever.
The bottom line for me with First Quantum is that I think it is seriously overpriced and that there are better things I can do with my money. Goodbye old friend.
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To read more how and when to sell stocks take a look at:
19 Cardinal rules on selling stocks
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To dig further into the issue of cycles check out the Motherlode Chapter 8. The Economy and the Stock Market – Cycles and Trends
That Chapter continues with these Sections:
8.02 Industry or sector cycles
8.04 Animal spirits and economic cycles
8.07 Underheated economy – recession
8.09 Declining prices of commodities
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
Want to dig deeper into the principles behind successful investing?
Click here for the Motherlode – introduction.
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