By Sam Stovall
The S&P Diversified Metals & Mining index has flipped in and out of the -- the list of industries with top S&P Relative Strength rankings -- over the past few months. Investors have snapped up shares of companies that have historically benefited from both a recovery in the U.S. economy and the accompanying threat of rising inflation. And copper producers, which predominate in this index, certainly fit the description of classic cyclical commodity companies.
Year-to-date, through Sept. 5, the industry subindex was up 43.1%, vs. a 16.1% rise for the S&P 1500 (the combined S&P 500, S&P MidCap 400, and S&P SmallCap600 indexes). Will this group continue to offer above-market performance? Leo Larkin, S&P's diversified metals and mining analyst, believes it will. He says mine production cuts, along with a gradual recovery in demand, will enable this segment to outperform.
However, while the analyst thinks the overall index has room to rise, he isn't as keen on key companies within the group. We'll get to why that is a bit later. But first let's take a look at what's behind copper's rebound.
Larkin thinks the 14-year low price for copper of 61 cents per pound, reached in November, 2001, marked a bottom. S&P sees a rebound in sales and earnings per share for copper producers as the market recovers from this low point.
Copper's fall was steep. After peaking in 1995 at $1.35 per pound, the average price dropped to 72 cents in 1999, mostly as a result of excess global production relative to demand. Larkin says demand bottomed in 1999, and has risen, albeit irregularly, ever since. Around the same time that demand hit its nadir, he notes, major copper producers began to cut output, thereby setting the stage for a cyclical recovery in the metal's price.
After reaching a 10-year high of 782,000 metric tons in 2001, the worldwide copper surplus (the amount of the metal produced vs. the amount consumed) declined to 245,000 metric tons in 2002, thanks to rising demand and lower output. S&P sees the surplus dropping again in 2003, and a production deficit for the full year is even a possibility.
Indeed, through 2003's first five months (latest available data), copper had a global deficit of 54,000 metric tons, vs. a global surplus of 192,000 metric tons a year earlier. The deficit occurred as consumption rose 2.0%, while production fell 1.9%.
Whether or not a deficit persists for the balance of 2003 remains to be seen, but Larkin expects consumption to exceed production, and he anticipates that copper's price will average between 78 cents and 80 cents per pound for the year. Through mid-September, the price averaged 77 cents.
Beyond 2003, S&P believes the prospects for a rising price are bright, based on its expectation of increased demand arising from greater infrastructure spending in Russia and China. Another positive: the curtailment of supply by bankrupt producers along with low levels of exploration spending in recent years. The latter should result in tighter supplies in the future as fewer new deposits are being put into production.
While the outlook for the industry overall is favorable, none of the stocks Larkin follows carry S&P's top investment rankings of 4 STARS (accumulate) or 5 STARS (buy). Why? Mostly, it's a question of valuation. For example, industry leader Phelps Dodge (PD ) is ranked 3 STARS (hold). Larkin doesn't think investors should add to holdings with the stock trading at 24 times his 2004 EPS estimate of $1.75.
Another leading player, Freeport McMoRan (FCX ), also gets a 3-STARS ranking from Larkin, but for a different reason. While he thinks Freeport is achieving significant operating improvement, he notes that all its mining assets are located in Indonesia, a country with a significant degree of political risk.
Industry Momentum List Update
For regular readers of the Sector Watch column, here's this week's list of the 11 industries in the S&P Super 1500 with Relative Strength Rankings of "5" (price performances in the past 12 months that were among the top 10% of the industries in the S&P 1500) as of September 5, 2003.
* S&P's stock appreciation ranking system for the coming 6- to 12-month period: 5 STARS (buy), 4 STARS (accumulate), 3 STARS (hold), 2 STARS (avoid), 1 STAR (sell).
Stovall is chief investment strategist for Standard & Poor's