After last year’s bloodbath, the economic outlook for 2009 is bleak. But at least for investors this grim news already seems to have been factored into equity valuations. The question is whether reality will prove to be worse than this pessimistic scenario, or (hopefully) slightly better. I fall into the latter camp. That’s not because I don’t recognise the dangers, but because I believe that the wave of government stimulus packages in America ($825bn), Asia ($672bn) and Europe ($100bn+) should help to bump up global GDP.
Tip of the week: Vale ADRs (NYSE:RIO), rated a BUY by JP Morgan
So if the near-term solution is to build more roads, bridges, airports, railways and schools, who will benefit? Civil engineers and the construction industry are the obvious options. But most of these operators also have significant exposure to the commercial and residential property markets, which will continue to burn cash for some time yet. So my preferred play is to dig into the miners. Companhia Vale do Rio Doce (Vale) of Brazil is my top pick.
Vale is the world’s second-largest mining group after BHP Billiton, with a market capitalisation of around $69bn. Its main output is iron ore (61% of sales) and nickel (17%), which it sells both inside Brazil and exports overseas to China, Europe and Japan. Its other interests are in bauxite, aluminium, coal and copper.
Not surprisingly, like its peers, Vale has suffered of late due to falling demand from steelmakers and collapsing metal prices. Yet because of its relatively low cost base, it is forecast to remain profitable and cash-generative during the recession. Wall Street expects 2009 sales and underlying earnings per share (EPS) to be $32.9bn and $1.93 respectively, rising thereafter as the economic cycle improves. I would value the stock on a through-cycle multiple of ten-times EPS (of $2), generating an intrinsic worth of around $20 a share.
What’s more, in contrast to some of its heavily geared rivals (such as Rio Tinto), Vale has a sound balance sheet, having walked away last March from a deal with Xstrata. At the end of September it had comfortable net debt levels of only $3.9bn (after raising $11.5bn in June 2008), equal to a modest one times 2008 earnings before interest, tax, depreciation and amortisation. This extra fire-power should provide ballast in the tougher times ahead, as well as allowing it selectively to pick up desirable assets on the cheap as many of its rivals become distressed sellers.
Of course, there are risks. Firstly, if the recession turns into a depression then this will hit the whole commodities eco-system. Secondly, annual negotiations are presently taking place with Chinese steelmakers who are pressing for a 40% cut in their iron-ore price. There’s also possible political instability in Brazil, inventory write-downs due to lower metal prices, and foreign-exchange fluctuations – more than 50% of Vale’s costs are based in Brazil but about 90% of its production is denominated in dollars.
Even so, as demand falters, Vale, BHP and Rio – who together supply 75% of the world’s seaborne iron-ore – are aggressively cutting production and moth-balling non-performing sites. As such, by 2010 I’d expect commodity prices to have stabilised, boosted by the near-term infrastructure spend of governments, coupled with the secular trends of urbanisation and industrialisation in developing countries.
Recommendation: BUY at $12.24
Each American Depository Receipt (ADR) represents one share in Vale
• Paul Hill also writes a weekly share-tipping newsletter, Precision Guided Investments.