To paraphrase a quote from Thomas Paine's The Crisis, "These are the times that try men's wallets," especially when one considers the bloodletting experienced by commodity stocks recently. This mini-meltdown was sparked by concern over rising global interest rates, continued hawkish comments from the Federal Reserve, and worry that -- as in the past -- central banks will overshoot and crimp global economic growth. To add insult to injury, most commodity companies also have significant operations in emerging markets, an area synonymous with risk in the minds of investors, and the first place investors flee in times of uncertainty.
Sounds like I'm suggesting that investors hit the sell button as rapidly as possible, right?
Not in the least. I actually believe that we are in the early innings of a commodity bull cycle, and I view the recent sell-off as an opportunity for aggressive investors to scoop up beaten-down shares in one of my favorite commodity plays: Aluminum Corp. of China (NYSE:ACH). Better known as Chalco, the company has seen its shares drop 31% since the beginning of May.
Sounds Foolish? Let's take a quick look.
Commodity cycles
Over the past century, commodity bull markets have averaged between 14-18 years. It's pretty obvious that we're currently in the midst of another one (four or five years into it, depending on who you talk to). For example, oil prices have soared from around $20 per barrel in late 2001 to around $70 per barrel currently, copper has jumped from a cyclical low of $0.60 a pound in October 2001 to more than $3.00 a pound in 2006, and gold has rallied from less than $300 per ounce to around $575 per ounce last week.
Without getting into the mind-numbing details of supply/demand imbalances -- i.e. the fact that very few new mine shafts have been sunk in over twenty years worldwide -- it's logical to conclude that this commodity bull market has further to run if history is any judge. This thesis is further underpinned by voracious demand from the rapidly industrializing economies of China and India. Simple demographics will also play a part in the long-term: By 2050 the world is expected to have a population in excess of 9 billion, up from 6.3 billion currently. The demand generated by a larger population coupled with a finite supply of commodities will inevitably lead to higher prices.
Of course, no bull market goes straight up, and while there were years during the last bull cycle (1968-1982) when the Commodity Research Bureau (CRB) Index was up more than 100%, there were also years that saw declines ranging from 15% to over 50%. This volatility, naturally, spills over into shares of commodity producers, and can be gut-wrenching -- as evidenced by the recent carnage in the sector.
In short, an investor in commodity stocks can profit handsomely during a commodity bull market, but must have a cast-iron stomach with regards to volatility, not to mention the patience of a saint. The pick I mentioned previously, Chalco, amply illustrates the point. Despite periodic elevator-like drops (including the one we are currently experiencing), investors who stayed the course saw their shares in Chalco advance more than 265% since early 2002.
Not too shabby, eh?
Well, fasten your seatbelts, this ride isn't over yet.
Aluminum Corp. of China
Chalco is the largest manufacturer of alumina and aluminum in China, producing approximately 7.2 million tons of alumina in 2005 (incidentally, that makes it the second largest producer in the world after Alcoa (NYSE:AA)) and more than 1 million tons of aluminum. At the end of fiscal 2005, the company's eight owned plants, and one associate plant, had annual production capacity of 8.3 million tons of alumina and 1.5 million tons of aluminum. These numbers leave the company some wiggle-room in terms of ramping up supply in a country where, according to rival Alcoa's estimates, aluminum demand is expected to grow at a 12.5% compound annual growth rate from 2005 to 2009.
Indeed, the above-mentioned estimate could prove conservative; industrial production in China grew at an 18% clip in May. Joe Muscari, Alcoa's CFO, recently noted that China's per capita consumption was 1/6th that of other top consumers like Germany and Japan.
Another aspect of Chalco that investors should consider is its access to supplies of bauxite, the basic raw material needed to produce alumina. With one exception, all of Chalco's refineries are located in the four Chinese provinces where 90% of the potentially accessible bauxite has been found, allowing the company to save on transportation costs. Furthermore, the company now derives 43% of its bauxite from its own mines, up from 33% two years ago, leading to margin expansion.
One last point: In addition to being punished for being an "emerging market" company, Chalco's shares have also been under pressure because of concerns over weakening aluminum prices. In my opinion, this concern is overblown; aluminum currently trades at a spot price of $1.11/pound, significantly higher than the $0.85/lb. averaged in 2005. Furthermore, Century Aluminum's (NASDAQ:CENX) president, Logan Krugar, recently said that he expected "healthy" global aluminum demand growth of 4%-6% in 2006 and 2007, but only a 2%-3% increase in production capacity.
If you're not convinced yet, take a look at Chalco's valuation. The company currently trades at a mere 5.4 times fiscal 2006 earnings estimates of $14.41, while offering a dividend yield of 3.8%. If you couple this mouth-watering valuation with Chalco's dominant position in the world's fastest-growing aluminum market, it would seem that now is the perfect time for risk-tolerant, patient investors to seriously take a look at these shares.
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Fool contributor Will Frankenhoff enjoys his time writing for The Fool more than playing golf or taking naps. He welcomes your feedback. Will does not own shares in any of the companies mentioned above. The Fool has a disclosure policy.
