What's Firing Metals Stocks' Furnace

The astronomical p-e ratios of some stocks are daunting, but a weak dollar and China's voracious demand is likely to keep prices high

By Tina Petersen

Metals stocks have witnessed an explosive jump over the past 18 months, with gains of up to 240% for copper stocks, 33% to 75% for gold outfits, and 80% to 85% for aluminum issues. That compares with a 36% average gain for stocks in the S&P 500 index since October, 2002.

Investors should be a little careful at this point, given that most stocks of metal makers are trading at 52-week highs and, in some cases, huge multiples. Even so, many analysts think this period of prosperity for metals makers and their investors could last a long while, as strong demand outside the U.S. drives up commodity prices.


  China is sucking in unprecedented amounts of commodity metal and scrap, for instance. And if the U.S. economic recovery continues -- and a weak dollar keeps on encouraging exports -- metal producers could continue to party. "We believe this dynamic will spur multiple episodes of outperformance, rather than the 'once per cycle' dynamic of the recent past," a recent report by Smith Barney/Citibank concludes.

It already has been quite a run. Consider U.S. copper producer Phelps Dodge (PD ). Its stock has risen from $23 in October, 2002, to around $90 a share. U.S. copper and gold producer Freeport Copper & Gold (FCX ) has shot up from $9 in October, 2001, to $44.

Similarly, aluminum giant Alcoa (AA ) has jumped from $18 a year ago to $38 -- and has further room to run, predicts Leo Larkin, metals equity analyst for Standard & Poor's, which like BusinessWeek Online and Platts is part of the owned by The McGraw-Hill Companies. Larkin points to strong, if moderating, growth in aluminum prices -- about 10% since January -- as an encouraging sign that Alcoa may have more upside.


  Daniel Roling, senior metals and mining analyst for Merrill Lynch, thinks the lowest inventory levels in years for many metals, as well as 98% to 100% operating rates at many metals plants, portend a further valuations boost for some stocks. Analysts also think that commodity prices, which are at six- to eight-year highs, should stay firm as long as global growth stays on track. Roling and Merrill Lynch both have holdings in Alcoa, Alcan (AL ), Inco (N ), and Phelps Dodge.

In its report, Smith Barney/Citibank said it expects metals prices to peak by midyear, then soften as new metals supplies appear. "We believe 2004 will be more challenging for metals investors than 2003," the report says. But even with some price-earnings (p-e) ratios at other-worldly levels (Phelps Dodge is trading at 1,852 times earnings), the report points to stocks it thinks are promising, such as Alcoa, with a p-e of 30.72, and Alcan, whose p-e is 53.75. Analysts also recommended Freeport, with a p-e of 40.38.

In steel, bankruptcies over the past three years have left two giant producers in charge: United States Steel (X ) and International Steel Group (ISG ), each of which produce about 20 million tons a year of carbon steel. Even though both stocks are trading near their 52-week highs, some analysts point to U.S. Steel as a good buy.


  Furthermore, Merrill's Roling believes that a "super cycle" might be at hand, in which investment in metals production capacity picks up, even as the market's dynamics change in a way that's beginning to alarm many U.S. manufacturers. China now consumes one-third of the metals produced in the world (the U.S. is No. 2, with 20%). Thus, some speculate that the Middle Kingdom may begin to produce high-end parts and components for export that could compete with value-added U.S. products globally.

Rough spots for metals producers? There could be a few. S&P's Larkin says he wouldn't be surprised to see a modest correction for the sector later this year, along with a possible correction in the overall stock market. Another analyst who asks to remain anonymous notes that it would be unusual to see such explosive growth in any sector "not followed by a correction."

Some industry execs are worried that Beijing -- concerned about the level of bank borrowing in China -- is trying to slow economic growth, which could hurt demand for metals. And there's always the worry that another war or terrorist attack could disrupt global demand.

No matter how you smelt it, however, China appears to be emerging as an insatiable importer of aluminum, steel, copper, and other metals. So, if the Middle Kingdom doesn't suffer a hard economic landing, the run-up in metals stocks could last a bit longer.

Petersen is managing editor of the Platts Metals Group. Check out more Street Wise columns

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