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April 14, 2006

Copper Stock Valuations
by Adam Hamilton

Last week I wrote an essay on gold stock valuations, which are nothing short of extreme today. Commodities investors need to be aware that the major gold stock indexes are riddled with gold companies losing money even at today's prices. And the major gold miners actually earning profits are trading near 75x P/Es on average.

While this certainly makes gold stocks risky at these valuations, it also creates opportunities. As I explained in my conclusion last week, the lower the profits of a commodities producer the faster they will multiply as commodities prices continue to rise. Gold stocks' low profits grant them enormous future profits leverage.

One of the greatest things about writing publicly is I am blessed with a great deal of outstanding feedback. I am very grateful for everyone who wrote in to help me further my understanding of the high gold stock P/Es. I heard from all kinds of folks ranging from battle-hardened investors to CEOs of publicly traded gold miners.

Before we delve into copper stock valuations, a quick summary of the feedback-based gold stock conclusions will be valuable to consider and relevant to this copper discussion today. In order for P/E ratios to be high, it takes a combination of high stock prices and low earnings.

Gold-miner stock prices are most likely high because a relatively large amount of capital has poured into a relatively tiny sector and driven up prices. While the total amount of capital deployed in gold stocks remains trivial compared to the broader markets, the gold world was so small and decimated after its multi-decade bear that even small amounts of capital in an absolute sense could drive mighty gains.

The gold-mining professionals who graciously wrote me were unanimous in their conclusions on why gold stock earnings are now relatively low despite the higher gold prices. They explained to me that mine managers strive to maximize the lives of their mines and the total reserves each mine commands. While this is an excellent long-term strategy and is very prudent, it doesn't always help short-term profits.

Gold deposits usually have a high-grade core surrounded by a halo of lower grade ore that gradually tapers off into rock with no gold. When gold prices are low, mine managers are forced to mine the high-grade core to cover their high fixed costs. They run this high-grade ore through their mills, which have fixed capacity, and it yields more ounces of gold per day. This is why global gold production rises when prices fall, companies have to mine their best ore to survive.

But high-grading drastically reduces the potential life of a mine. So when gold prices are high, mine managers start mixing in low-grade halo ore with any high-grade core ore they are mining. They run this rock through their fixed-capacity mills which of course produces fewer ounces per day than pure high-grade ore would. But at higher gold prices the mines don't need to sell as many ounces to cover their expenses and earn modest profits, so they take advantage of the higher gold prices by mining lower-grade ore that wasn't economical at lower prices.

This strategy maximizes reserves and mine lives, but it can reduce short-term profits. Every mining professional who wrote me including geologists, mining engineers, and mining CEOs believed this low-grading was the reason gold mining profits haven't leveraged gold like they ought to. On the bright side, this practice means global gold production tends to fall when gold prices rise. Lower global gold supplies will lead to higher gold prices in the future.

So relatively lots of capital chasing gold stocks combined with lower-grade ore being mined which reduces profits are probably the key factors explaining the extreme gold stock valuations we are seeing today. As gold's bull continues higher these valuations still should fall, but it seemingly takes longer than expected due to mine-management strategies to maximize mine lives and reserves.

A fascinating contrast to the extremely richly valued gold companies is the bargain copper miners. While gold is only up 133% bull to date, copper is up a magnificent 357% in its own bull since late 2001! With copper gains nearly tripling those of gold, copper miners have had far more favorable price environments to leverage commodities price gains than gold miners.

In many ways copper miners are probably blazing a valuation trail gold miners will follow once gold's gains start catching up with other commodities' gains. In order to investigate the evolution of copper stock valuations since 2000, I am going to use the same methodology I used last week. Like I did with gold, I will take a look at one of the largest and most respected copper miners in the world.

As I mentioned last week, historical valuation data is difficult if not impossible to find. But every month at Zeal we crunch valuation data for every S&P 500 component company in order to calculate P/E ratios and dividend yields for the general US stock markets for our subscribers. One of the world's premier copper companies is included in the S&P 500, the venerable Phelps Dodge. Founded in 1834, PD entered copper mining in 1881 and has since grown into one of the most respected and revered major copper miners.

Just as Newmont was a proxy for major gold-miner valuations last week, PD is an excellent proxy for major copper-miner valuations in this analysis. Today's charts plot the PD stock price on a daily basis underneath its market capitalization and P/E ratio on a monthly basis. Phelps Dodge shows exactly what a major commodities producer should do in a secular bull. Even though its stock price has skyrocketed, its valuation has simultaneously plunged!

Phelps Dodge stock is up 705% since late 2002, a spectacular gain for any major miner. Early commodities investors who saw the writing on the wall regarding global copper production falling short of world copper demand for years to come have already reaped fortunes going long elite copper stocks. Interestingly PD's market cap is up by a similar amount, which suggests it has been exemplary in avoiding dilution.

Last week in Newmont's case, nearly two-thirds of its total gains in market value since 2001 have been lost to stock investors because it has heavily issued new stock for acquisitions and compensation. In contrast Phelps Dodge has not been issuing a lot of stock which is why its yellow market-cap line so closely follows its blue stock-price line in this chart. Indeed if our market-cap data was daily like the stock-price data, the match would probably be pretty darned close to exact.

But the really fascinating aspect of this chart is not the lack of stock dilution, but PD's extraordinary valuation journey since 2001. Back in May 2001 copper was languishing under $0.80 per pound and copper miners were struggling. PD was sliding under $20 a share (split-adjusted) and trading at an ugly 137x earnings. To put this into perspective, that same month the notorious NASDAQ bubble stock Cisco Systems was trading at 106x itself.

While PD looked horrible back then from a valuation standpoint, astute investors were starting to realize that a new Great Commodities Bull was being born. Investment in commodities infrastructure, including world copper production, had been largely neglected for decades while investment capital chased the hot bubble sectors in technology. While supply capacity was rusting, Asia was starting to industrialize fueling potentially huge world demand. The odds favored commodities prices rising dramatically due to their structural deficits.

Not long after this, things got so tough in copper that PD started losing money. It reported no profits between mid-2001 and early 2004, as the dotted red lines above indicate. Its stock price drifted listlessly sideways under $20 for a couple more years and investors deserted it. Even though PD was actually doing fairly well compared to the carnage in general stocks from 2000 to early 2003, not many investors believed in the coming copper bull. And I am certainly guilty here too. Back then I was concentrating on trading precious metals stocks and energy stocks, not the base metals producers.

But as we'll see below, copper prices started surging in mid-2003 on soaring global demand led by Asia. In just three quarters copper went from about $0.75 to over $1.25 a pound, a spectacular gain of about two-thirds. While PD didn't start earning profits again instantly, astute investors responded immediately when copper started surging. These early contrarians bid PD from about $15 to over $40 in less than a year.

Now why would smart contrarians, who tend to be value investors, buy a company with no earnings for years that had last traded around 125x? Because they understood the compelling nature of commodities profits leverage.

Commodities are always in demand so a given producer has no problem selling every last pound of copper it can mine. Commodities producers are unique among sectors as they have a guaranteed global market for virtually unlimited amounts of their products. On top of this, the costs involved in large-scale metals mining are largely fixed. It takes the same amount of capital to build and operate a mine whether copper is trading at $0.75 like in early 2003 or $2.75 as today.

So big copper miners like Phelps Dodge, that were used to the challenging sub-$0.75 per pound copper prices of the late 1990s and early 2000s, had been building mines designed to be profitable at low copper prices. I haven't looked at PD's old annual reports, but imagine if its costs had run $0.70 while it was selling copper at $0.75. This had the potential to yield a modest $0.05 profit if the company could keep its admin costs in line.

When copper prices started rising, PD's costs may have risen modestly due to higher energy prices but they lagged far behind its selling price. Let's assume, once again hypothetically, that when copper ran above $1.25 in early 2004 PD's costs only rose to $0.80 or so. This yields a big $0.45 per pound profit. Thus a 67% rise in the copper price from $0.75 to $1.25 led to a mammoth 800% increase in its profits. The old $0.05 low-copper profits rocketed to $0.45 per pound once copper joined the commodities bull!

Profits leverage is the most important reason investors buy commodities producers during a secular commodities bull. The ultimate gains in profits and ultimately stock prices that elite producers are likely to see almost always utterly dwarf those in the underlying commodities themselves. Buying copper miners, while they do have company-specific risks, is almost certainly going to be far more lucrative than buying and holding (rolling over) copper futures if margin is not used in either case.

Back to this chart, in recent years PD stock has soared 705% higher. And even though it started at extremely high valuations and then was losing money for years, its valuation has contracted a phenomenal 95%! Indeed late last year, even as PD stock was carving a new all-time high, it was only trading near 6x earnings! Such low valuations are awesome buying opportunities usually only seen once every third of a century or so in the general stock markets.

This lesson is so critically important for investors to really understand. During a secular commodities bull, rising commodities prices drive profits growth far more rapidly than underlying commodities gains. Thus even as stocks of elite producers soar, their valuations fall and they become better and better bargains relative to their earnings streams. This phenomenon can last for much of an entire commodities bull, over a decade.

Now skepticism is healthy, it is essential to protect oneself from the snake-oil salesmen that breed like rabbits in the financial markets. One problem with this chart is the fact that PD went for years without earning profits, hence its valuation data is incomplete. The objection could be raised that PD's awesome profits leverage based on its short period of extreme P/Es in 2001 compared to its recent couple years of great earnings is reaching a bit. Honestly I would have been much happier too if PD had earned money in 2002 and 2003 so my valuation chart would be fully populated.

But thankfully the markets are fractal in nature, the same phenomena appear at different scales. This next chart zooms in from 2003 onward and looks at PD profits leverage over the last two years only, the period of time when Phelps Dodge started consistently reporting profits again. Amazing profits leverage is readily apparent on this most recent scale too, even if the exact tops and bottoms in PD's stock price and P/E are not cherry picked.

Exactly two years ago in April 2004, an interesting convergence occurred. Phelps Dodge was trading near $30 a share (split-adjusted) while it was also trading near 30x earnings. Since then PD stock has more than tripled, so it would not be too hard to assume that its valuation must still be high as well. But as this chart shows, even while PD tripled its valuation plunged by two-thirds!

Relative to its earnings power PD is a better deal today at $85 than it was two years ago at $30. Stated another way, with a 3x gain and now at 1/3rd the valuation Phelps Dodge's profits have risen 3x faster than its stock price. Profits leverage is very real friends! It is readily evident even during shorter timeframes within a secular commodities bull.

So why are copper stocks like Phelps Dodge thriving to such an enormous degree? Because the action in copper prices has been so awesome. My final chart this week shows PD stock as our copper stock proxy rendered on top of copper prices. Amazingly PD has a staggeringly high 0.984 correlation with copper on a daily basis. Thus in statistical r-square terms, 97% of PD's daily price action is likely predictable and explainable by copper's own daily price action!

While PD's stock price and P/E are slaved to the right axis, in this chart I want to focus your attention on copper on the left axis. Copper is plotted in red, its 200-day moving average in black, and its average closing price in each calendar quarter in white. It is hard to believe, but the already inexpensive copper stocks look to be getting even cheaper as soon as Q1 earnings are reported!

Starting in Q1 2005, copper was averaging about $1.47. By Q2 it climbed slightly to $1.53. At the time these prices seemed like a wonderful windfall and indeed PD's valuation was steadily dropping into mid-2005. But copper has an interesting tendency that I discussed recently in another essay. Unlike gold or silver which tend to correct down after they hit new highs, copper tends to grind sideways and consolidate instead.

In both early 2004 and early 2005 after copper hit new bull-to-date highs, instead of falling rapidly to its 200dma like many commodities copper instead just consolidated sideways. Note above that the red copper line doesn't fall back down to its black 200dma line after a new high, rather it meanders sideways near its latest highs and waits for its 200dma to rise and catch up with it. So while copper certainly could crash, anything is possible in the markets, there is no evidence yet in this particular bull that it is in the mood to do anything other than consolidate.

These consolidations occur due to fundamentals. World copper demand continues to rise faster than global copper miners are able to raise production, and above-ground stockpiles of this metal are dwindling. So with the possible exception of this latest blistering surge from $2.25 to $2.75 in just the past month, this copper bull has been rising in an orderly fashion with full fundamental justification. If copper prices remain high due to its worldwide structural deficit, copper-mining profits will continue to be mind-blowing.

Back to Phelps Dodge as our copper stock proxy, its profits continued to climb faster than its stock price in 2005. Average copper prices rose 11% in Q3 and 19% in Q4 of last year. It was during this period that PD's valuation fell to a minuscule 6x earnings! It was back up near 11x this week since its stock price has been so strong, but the actual event that excited me enough to write this essay happened Tuesday morning.

I was working out at o-dark-hundred Tuesday morning and watching futures action on Bloomberg, and the aluminum giant Alcoa announced its Q1 earnings. Not surprisingly since aluminum has been so strong, AA reported record profits. No big deal I thought, welcome to the commodities bull. But Wall Street, for some reason, thought this was unexpected. Alcoa rocketed up 6.5% virtually instantly in pre-market-open trading on its positive earnings surprise.

Now Alcoa is trading around 24x earnings, aluminum stocks are nowhere near as cheap as copper stocks. And as this chart shows, the average copper prices in Q1 were 11% higher than in Q4, when copper companies also reported record profits. So in light of these developments, we have the potential for a rare combination of events here that could lead to major copper stock buying in the coming month or two by institutions and value investors.

Average copper prices were 11% higher last quarter than in Q4. Copper stocks are trading at very low valuations and the copper bull is not yet widely known out of hardcore contrarian commodities-investors circles. As Alcoa showed, Wall Street isn't really paying attention yet since record earnings surprised it. So when copper companies report Q1 earnings soon, there is a decent chance these positive earnings surprises of all-time record profits will lead to a great deal of institutional buying pressure on copper stocks.

Few things move big companies more rapidly than earnings surprises, and the combination of massive positive earnings surprises coupled with extremely cheap valuations is a perfect recipe for elite copper stocks to really thrive in the months ahead. And even if copper corrects back to $2.25 or even its 200dma near $2.00, copper mining profits will still remain huge compared to the low copper stock prices for months or years to come.

In light of these dazzling copper stock fundamentals and their huge potential as more investors figure out what bargains they are, I believe it is very important that commodities-stock investors be diversified into elite copper and other base metals miners.

In our current Zeal Intelligence newsletter published in early April, I outline several elite copper majors as well as many more diversified miners with low P/Es and heavy base metals exposure. These elite companies' low valuations suggest their bulls are just getting started despite their excellent stock performance over the past year.

While I'm a mere mortal and cannot see the future, it does look like the odds favor a lot of big institutional interest in copper and base metals miners once their utterly spectacular Q1 results are released. If you want a shot at getting ahead of this wave, please subscribe to our acclaimed monthly newsletter today to read about these specific-stock opportunities. New e-mail PDF-edition subscribers will get this current issue free, your paid subscription will start in May.

The bottom line is copper stocks are overwhelmingly trading at extremely low valuations today. Since copper has advanced so much in percentage terms in its own bull, its producers are really exemplifying awesome profits leverage in the real world. Today's low copper stock valuations prove that commodities-stock investing is not always at odds with conservative value investing as gold stocks seem to now suggest.

Despite copper stocks' incredible opportunities, this sector remains largely unloved even among commodities investors. And I have yet to meet a mainstream investor who has any idea at all that copper has been in an immensely powerful bull market. Sooner or later this knowledge will spread and investors will rush in driving copper stocks much higher.

Adam Hamilton, CPA
Zeal LLC.com

Do you enjoy these essays? Please help support Zeal Research by subscribing to Zeal Intelligence today! &www.zealllc.com/subscribe.htm

If you have questions I would be more than happy to address them through my private consulting business. Please visit www.zealllc.com/financial.htm for more information.

Thoughts, comments, flames, letter-bombs? Fire away at zelotes@zealllc.com. Due to my staggering and perpetually increasing e-mail load, I regret that I am not able to respond to comments personally. I WILL read all messages though, and really appreciate your feedback!

Mr. Hamilton, a private investor and contrarian analyst, publishes Zeal Intelligence, an in-depth monthly strategic and tactical analysis of markets, geopolitics, economics, finance, and investing delivered from an explicitly pro-free market and laissez faire perspective. Please visit www.ZealLLC.com for more information, www.zealllc.com/samples.htm for a free sample, and www.zealllc.com/subscribe.htm to subscribe.

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