1) Fundamental value2) Technical set up
3) Market sentiment
Let’s take a look at market sentiment initially. When we discuss market sentiment, this involves the entire sector as a whole, in addition to the stock market in general. Remember, when a stock moves up or down, a certain portion is based on the stock itself, another portion is based on the sector and a third is based on the overall market.
Even the greatest stocks will go down if their market segment and the overall stock market is crashing. They can, however, outperform on a relative basis. This is important to remember, the difference between relative and absolute performance.
Obvious to any investor in the mining sector over the past year, commodities have dropped sharply, causing all mining stocks to drop as well. It doesn’t take a rocket scientist to understand why that would occur. The lower the price is of a commodity, this means lower revenue, all else being equal.
However, another factor that many investors earlier in the year were not factoring in was the higher costs associated with mining. Over the past few years, mining companies have expanded massively, buying even marginal properties and causing costs to increase.
Now you have a situation where the end product (the commodity) is dropping in price and the cost to produce the product are going up. That’s not good situation.
Mining stocks have now gone from too optimistic to far too pessimistic, as the pendulum has swung significantly over the past year. As some investors might be aware, many mining stocks have written off billions of dollars in assets that they deem no longer economic, and are reducing expansion and supply.
This transition is obviously troublesome for existing shareholders, but going forward the lower levels of supply will certainly help bring back balance into commodity markets.
From this standpoint, the pendulum has swung so far in one direction that the mining sector overall appears to offer attractive prospects. This is obviously a cursory examination, as each commodity needs extensive in-depth research.
Vale trades with the forward price-earnings ratio of 8.1, and marginally above book value at 1.13. While this does appear cheap, one does have to be aware that earnings are set to decline for fiscal 2014. While most analysts estimate revenue will increase from fiscal 2013, the higher costs will continue to keep earnings muted.
That’s the consensus, however we believe the company has the potential to cut additional costs increasing the potential that they could beat earnings estimates. Referring to the earnings conference call following their last quarter, the company stated that they are focused on creating a leaner corporate structure through cost-cutting.
This is the cost side of the equation, which the company is determined to rein in. Now looking at the revenue side, we are seeing recent evidence that China is beginning to rebound, and Europe is actually showing signs of life.
It appears to us that most Wall Street analysts have become overly conservative and pessimistic in terms of the potential for growth rebounding and the company’s ability to reduce costs. With central banks around the world priming the pump with stimulus, any marginal improvement will have a positive impact on the type of commodities that Vale supplies.
One note regarding production revenue. While Vale is still largely associated with iron ore, which comprises 54% of 2013 revenue so far, the company does have additional segments of revenue generation including base metals, which is approximately 15%, fertilizer nutrients, which is 7% and logistical services at just under 4%.
Even throughout this recent downturn in commodity prices, the company is still able to generate a decent profit and operating margin, in addition to a return on assets of over 6.3%. Many mining companies have suffered tremendously, to the point that they are some incurring negative operating margins and ROE.
Usually during times of stress in a given market, the strong companies actually get stronger. In this case, Vale might come out ahead over the next five years versus other mining companies.
This multiyear, weekly chart of Vale is here to show you that during times of extreme optimism or pessimism is when one should look at accumulating or distributing (selling) shares. Underneath the chart, is the relative strength index (RSI).
Note the circled areas which indicate extreme levels of optimism and pessimism. A stock many times will move far beyond fair market value, and it’s during these periods that open the door to attractive entry and exit points. Also note however that just because a stock is overbought or oversold does not mean it has to reverse. During 2007, Vale’s RSI was in an overbought condition for quite a period of time, and it still continued moving up before ultimately selling off in 2008.
As all indicators in technical analysis, these are simply guideposts to help manage entry and exit decisions that can help in addition to fundamental analysis.
Having said all that, at this point, the stock is hitting a significant amount of resistance on the daily chart, as the previous holders of the stock in the first half of 2013 will look to exit at least part of their position.
However, on the daily chart, the stock continues to make higher highs and higher lows, a very bullish sign. As long as the stock continues to make higher highs and higher lows, we believe the up trend should continue.
Considering to move up over the past couple of months, a pullback and consolidation is likely. An attractive entry point would most likely be in the $15.75-$16.00 region, which is this 38.2% Fibonacci retracement level. If the stock broke the lows of early August, approximately $13.50, this would bring red flags to many technical analysts, and we would believe there would be a significant number of stops in that region.
On the weekly chart, the stock still appears relatively weak. However, if the stock can remain in the $15-$17 range, this could be a good base from which it could build enough momentum to breakout. With the RSI neutral-slightly bullish, there is no worry about the stock being overbought.
In addition, we’ve seen large option trading occurring as buyers have begun accumulating the October 18 calls. This makes sense from a technical point of view, because it is at this point that if breached, we could see a significant amount of buying pressure take hold as technical analysts would register a break above the 61.8% Fibonacci retracement.
Market sentiment for most commodities has moved up from the extreme levels of pessimism over the past few weeks. With economic data showing improving signs from China and Europe, as well as central banks around the world continuing monetary stimulus, there is a high probability that many investors have priced in the worst for mining stocks.
Fundamentally, the company is now on pace for significant cost cutting measures, making the firm much leaner, focused on creating shareholder value and increasing the likelihood of positive earnings surprises. In addition, the entire mining sector is now undergoing a significant decrease in expansion and supply, which should lead to better supply and demand dynamics.
Technically, we are seeing a significant amount of buyers enter the stock, both through analysis of the charts as well as the options market.
This is a cursory look at Vale, and we are not making any specific buy or sell recommendation but merely voicing our opinion of the current situation. Each individual investor must conduct their own due diligence of both the company, the market sector as well as their own financial situation and risk parameters.
If you would like to know how we would create a trading strategy using companies like Vale, then check out our Aggressive Investor Newsletter.
Originally published at BehindWallStreet.com