A Rare Chance to Buy the Best Mining Stock on the Market for Dirt Cheap

Michael Vodicka's picture

Thursday, June 7, 2012 - 11:30am

by Michael Vodicka

Most of the time, when the value of a company's products or services increase, so does its share price. 

Take General Motors Inc. (NYSE: GM) for example. If the company were suddenly able to sell its cars for 5% more next week, 20% more in three months and possibly 35% by the end of the year, then its share price would probably be screaming toward the moon. Rising prices are usually a sure-fire way for companies to grow earnings and light a fire under shares.

But I've discovered a group of companies that are defying logic. These companies have seen the value of their goods sold skyrocket during the past few years, along with earnings, yet the group trades below levels from two years ago. 

That's a rare opportunity on the Street -- the conditions under which historic investments are made. It's when correlations become completely skewed and everyone is on the same side of the boat.

Take a look at what the price of gold has done during the past five years relative to gold miners in the Market Vectors Gold Miners ETF (NYSE: GDX). Amazingly, gold stocks have dropped to multi-year lows in spite of physical gold gaining more than 130%.

The trend accelerated last September when gold stocks took a pretty serious beating as physical gold suffered a rare pullback. Since then, gold stocks have been significantly weaker than spot prices, currently trading at record spreads. As you can see in the chart below, the disconnect has never been greater.

GDX vs GLD

If you're looking to cash in on this historic divergence, then my favorite way is with Freeport McMoRan (NYSE: FCX), one of the world's largest mining companies. Freeport is a high-profile name in the world of mining and precious metals. The company's interest in silver and copper give it more product diversification than you would get from a pure gold miner. It is also the world's largest producer of Molybdenum, used as an additive in the production of steel and alloys. As a large company with a $38 billion market cap., shares won't rally like a junior miner on rising precious metals prices, but this also provides more stability for investors looking for a smoother ride. Freeport has the distinction of owning the world's largest gold mine, known as the Grasberg Mine, located in Indonesia. 

Freeport's share price has fallen sharply in the past 18 months, dropping from above $60 in January 2011 to a recent $33. This 45% decline is a sharp underperformance of both the S&P 500's 3% gain and spot gold's 14% increase. But what is most interesting about this movement is that it comes as earnings and estimates have held up well, with 2011 full-year earnings per share (EPS) of $4.77 up from $4.59 in 2010.

Financials
Beyond earnings and valuation, Freeport will likely continue to benefit from its strong financial profile. The company has $4.5 billion in cash and equivalents on the balance sheet, mostly in line with last year, against $3.5 billion in long-term debt. Freeport is also a free cash-flow monster, producing more than $4 billion in 2011 and trading at just 13 times free cash flow, compared with the industry average of 39. This strong financial profile enabled Freeport to raise its dividend by 25% in its most recent quarter to $1.25 per share, good for a current yield of 3.9%. This will also enable Freeport to invest in future growth and develop additional mining assets.

In terms of catalysts, the biggest trigger for precious metals and Freeport is movement from the Federal Reserve and other global central banks. In its late April meeting, strong economic data and bullish equity prices led the Fed to downplay the chances for further monetary stimulation. But since then, we've seen two weak jobs reports and sharply-falling equity prices. This gives the Fed much more flexibility to be active, so the market will be watching its next meeting set for June 20-22 very closely. If the most powerful central bank in the world hints at more movement, then precious metals prices and mining stocks will be set to soar.

Risks to Consider: In terms of weakness, the greatest threat to Freeport is the strength of the global economy. Weaker global gross domestic product (GDP) growth will likely stifle industrial demand for copper, silver and molybdenum while tempering demand for gold as a weak economy drives deflation instead of inflation.

But even if global GDP growth stays strong, higher fuel and mining costs are a potential threat to Freeport's profitability and strong margin profile.

Action to Take--> Gold, mining and resource stocks are not for the faint of heart, characterized by high levels of volatility and sensitivity to the global economy. But as a larger name in the space, FCX provides more stability and diversification than you would get from a junior miner or a pure play on gold.

Despite weakness in the share price in the past few years, Freeport's earnings profile has held up well -- at least much better than movement on the stock chart. This has presented a rare opportunity to buy shares at a big discount relative to historic levels. If shares simply return to the 10-year average forward price-to-earnings (P/E) ratio of 11, then full-year earnings of $4.07 would place shares at $44, a 33% gain from current levels. Looking further out, the 2013 full-year estimate of $5.29 means shares would have to gain 76% to reach historical valuation.

Michael Vodicka 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.