News Analysis date published New: 
Friday, August 24, 2012 - 09:00
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Friday, August 24, 2012 - 09:26
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Friday, August 24, 2012 - 09:00

Why it Pays to Invest Like a Contrarian

Friday, August 24, 2012 9:00 AM

No less a sage than Warren Buffett has taught us to be greedy when others are fearful and vice-versa. That's true for almost any stock. But it's particularly good advice for commodities investors.

A retailer like Wal-Mart (NYSE: WMT) or a consumer products vendor such as Coca-Cola (NYSE: KO) might be able to deliver consistent growth year after year. But raw materials such as copper, coal and platinum are different -- they are susceptible to boom-and-bust cycles.

If you invest during the height of the boom, then you know what's coming next.

It's pretty simple, really. Whenever a commodity price starts to soar, more people are anxious to dig it up. New miners enter the game, while existing ones pour cash into expansion projects to ramp up their output. Before long, everybody and their cousin are bringing in new supplies and glutting the market.

When that happens, prices inevitably begin to fall. When they get low enough, financial incentive disappears and producers decide it's no longer worth it. Mines begin to close. New projects are delayed or cancelled. In time, the supply surplus thins and turns into a deficit -- causing prices to reverse course and move higher.

Prices for this key industrial building block have plunged amid the deteriorating economic picture. But today is irrelevant -- tomorrow is what counts.

Incidentally, this is exactly what we saw in the natural gas market. For example, I told readers of my Scarcity & Real Wealth newsletter that Chesapeake Energy (NYSE: CHK) had voluntarily suspended 1 billion cubic feet of gas production per day, and that others had followed with their own curtailments. Meanwhile, the lack of incentive has forced energy producers to abandon most dry-gas fields and funnel their leasing and drilling budgets into oilier plays. Natural gas prices have already responded by rebounding about 45% off their lows.

This repetitious cycle has played out over and over again. But identifying those inflection points when the pendulum is about to turn is tricky, if not impossible. So the surest strategy is to invest in companies like Silver Standard (Nasdaq: SSRI), an established miner sitting on 189 million ounces of proved silver reserves,.when nobody else wants them. Last September, anyone with $2.36 billion to spare could have bought the company. That enterprise value (essentially market cap minus cash) equates to a cost of about $12.48 per ounce. The math works out the same on a per-share basis.

But investors aren't quite as upbeat these days, and small mining stocks have retreated sharply. Shares of Silver Standard have fallen to $12 from $32, slashing the enterprise value to $815 million. This means the firm's silver hoard is now priced at just $4.30 per ounce.

Nothing has changed from an operating standpoint. The company is exactly the same as it was almost a year ago. Well, that's not entirely true. Operating costs have fallen, so profit margins are a bit wider now. So it's just a matter of waiting for the next up cycle.

Songwriter Tom Petty said it best -- the waiting is the hardest part. But if you want to put some really big gainers in the win column, then you must be willing to be patient and withstand a barrage of discouraging news.

BHP Billiton (NYSE: BHP) is a textbook example.

In the summer of 2002, things didn't look good for the Australian conglomerate. Annual revenue for the year ended June 30 had just dropped to $17.8 billion from $19.0 billion a year earlier. Commodity prices had weakened for the firm's aluminum, copper, nickel, chrome, diamonds, silver, oil and zinc. And shipment volume was falling for everything from coal to titanium, reflecting the soft global economy.

If that weren't enough, the company was also hit with hundreds of millions in impairment charges for discontinued operations. And to add insult to injury, corporate tax rates for energy producers in the U.K. were raised to 40% from 30%, hitting the bottom line.

Management was candid. The outlook section of the annual report began with this sentence: "There is cause for concern about the global economy."

The day that report was released, BHP Billiton could be had for less than $8 per share. But rather than focus on the issues of the day, it would have been far more constructive for investors to weigh the cheap stock price against the long-term potential. BHP Billiton is one of the world's largest metals and energy empires and had dozens of growth projects under construction.

In the end, value always shines through. As you can see from the chart below, BHP began rallying shortly after and went on to deliver a 625% return by the end of 2007.

Again, this is exactly why it pays to seek out quality stocks that are overlooked and underappreciated.

Risks to Consider: I can guarantee you that many of the same investors who were buying the stock enthusiastically back in September are dumping it today. There's just too much risk, they say.

Apparently, $12 silver is a sure bet, but $4 silver isn't.

I'm not sure I understand that logic. Letting some air out of the stock makes it safer, not riskier. Would you rather fall from 32 feet or 12 feet? Yes, the world's economic prognosis has dimmed, and Europe's debt crisis is a viable concern. But since 11 of the firm's 12 mines are still under construction and won't be open for a few years anyway, who cares about today's problems?

Action to Take --> Nobody likes to put their hard-earned money on the line when stocks are sinking and the headlines look bleak. But ask yourself this: has Silver Standard's merchandise been damaged? Nope. It's still safely tucked away in the ground.

But thanks to anemic jobs growth, tepid retail sales, weak manufacturing surveys and other dour economic signs, investors can get their hands on that silver for a third of the price they would have paid six months ago. That tradeoff seems perfectly acceptable to me -- I bought 100 shares of Silver Standard for my Scarcity & Real Wealth real-money portfolio not long ago.

P.S. -- Although he is an expert in the area, oil and gas is far from the only arena Nathan is profiting from. Scarcity & Real Wealth aims to profit from the rarest and most valuable assets on the planet -- precious metals, agricultural commodities, energy, and other natural resources. These critical inputs are in short supply, yet worldwide demand is on the rise, making these assets some of the best investments on Earth. You can learn about one important supply/demand imbalance Nathan has found that will be making headlines next year by visiting this link (and without having to watch a lengthy video).

Nathan Slaughter does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC owns shares of KO, CHK in one or more of its “real money” portfolios.