Explorer stocks had a mixed week due to weaker market and some profit taking as SQM reported another strong quarter with earnings up 857% year-over-year. Positive second-quarter corporate earnings reports and the flattening of still-high inflation seemed to settle investor nerves and despite this week’s pullback, the S&P is up 17% from its June lows. This week we go to a big resource play on a strategic growth trend that is powered by Dr. Copper.

Cabot Explorer Issue: August 18, 2022

China Bull Ray Dalio Sells Alibaba

Explorer positions had a mixed week due to a weaker market and some profit taking. SQM reported a strong second quarter and CVS hit with after-market news of a potential opioid-related fine. Strong earnings and the flattening of still-high inflation seemed to settle investor nerves and despite this week’s weakness the S&P is up 17% from its June lows.

Bridgewater Associates founder Ray Dalio, perhaps the biggest bull on China on Wall Street, sold his firm’s entire stake in e-commerce giant Alibaba (BABA) as well as a number of its other holdings in U.S.-listed Chinese stocks. To be fair, Bridgewater is keeping Tencent (TCEHY), which unfortunately just posted its first ever year-on-year quarter of declining revenue.

Why? Certainly a number of reasons played into this decision. These include a slowdown in China’s economy, rising U.S.-China tensions, and the 200 Chinese companies whose shares trade in the U.S. facing possible delisting because American regulators aren’t able to verify their financial audits.

While Beijing and Washington continue to negotiate access to the audits, some Chinese companies aren’t waiting. On August 12, five of China’s largest state-owned businesses such as China Life and Petro China announced that they plan to delist from the New York Stock Exchange.

Meanwhile, tech giant Alibaba Group Holding Ltd. is seeking a primary listing in Hong Kong, a move that may signal its own eventual exit from U.S. markets.

This audit regulatory issue started with the 2002 Sarbanes-Oxley Act, enacted in the wake of the Enron Corp. accounting scandal, requires that all publicly traded companies make their audit work papers available for inspection by the U.S. Public Company Accounting Oversight Board, or PCAOB.

Only two jurisdictions still don’t: China and Hong Kong. Congress took action by passing the Holding Foreign Companies Accountable Act, which says companies can’t trade on U.S. exchanges if their audits aren’t made available for inspection for three consecutive years. The Chinese companies say national security law prohibits them from turning over audit papers.

What does this mean for American investors? Any delisting can’t happen this year or even in 2023, since a company would be delisted only after three consecutive years of non-compliance with audit inspections.

This regulatory backdrop could lead to some real Chinese stock bargains that I will try to monitor. The best opportunities may come after a delisting when the shares trade over-the-counter, or OTC. There is nothing wrong with buying what I call “pink sheet blue chips,” though liquidity might be an issue.

This week’s new idea is an American resource company with an international empire that benefits from one of the highest-profile trends -clean tech.

New Explorer Recommendation: Freeport-McMoRan (FCX)

Stocks are facing headwinds, but what about other asset classes like commodities? They offer investors a great hedge on inflation, and as plays on real assets, offer welcome diversification.

But with commodities, timing is everything.

Some smart analysts believe we are at the beginning of a commodity super cycle since stocks have greatly outperformed commodities over the past decade.

This conviction is supported by the clean energy revolution that will electrify the grid and demand much more tech and industrial metals such as copper.

It is hard to imagine a clean energy future without a lot of copper. For example, the average electric vehicle (EV) uses about 4X as much copper as the average gas-powered car. Electric vehicles have passed an inflection point and account for 5% of new-car sales, a tipping point that in other countries has led to 25% adoption within four years. China is at the heart of this ecosystem and in a typical year, consumes about half of global copper production.

Concerns about the possibility of a recession have weighed on the copper price since April, but those worries lack the big-picture view. Given that the U.S., Europe, and other parts of the world are transitioning to green energies, demand for copper should expand.

Copper is a key material used in electric vehicles, solar panels, and other green energy products because its conductivity is second only to silver. However, even though copper prices plunged in July, S&P Global reported that copper demand was skyrocketing while demand couldn’t keep up. Goldman Sachs expects demand for the metal to double by 2035.

The price of copper, like most commodities, is volatile. In the past decade, it’s been as low as $1.90 per pound in 2016 and it soared to almost $4.80 per pound as the economy recovered from the pandemic in the spring of 2021. It has now settled at about $3.64.

According to Phoenix-based Freeport-McMoRan’s (FCX) second-quarter earnings report, it operates seven open-pit copper mines in North America, many of which also produce molybdenum, gold and silver. All but one of its North American copper mines is wholly owned, and Freeport-McMoRan holds 72% of the joint venture on the last one. I like this exposure to gold and silver because it adds another dimension to the company’s asset portfolio through diversification.

Freeport-McMoRan also owns two copper mines in South America and one of the world’s largest copper and gold mines in Indonesia (Grasberg).

Every 10 cents of price movement has a sizable impact on the revenue and profitability of a copper and mining giant such as Freeport-McMoRan.

For example, management believes the company currently has earnings before interest, taxation, depreciation, and amortization (EBITDA) sensitivity of $430 million for every $0.10 per pound move in the price of copper. For reference, Freeport’s EBITDA was around $10 billion in 2021, when prices were mostly well above $4 a pound.

According to Chief Financial Officer Kathleen Quirk on the recent earnings call, the company earns "$6 billion per annum at $3 copper to $15 billion per year at $5 copper, with operating cash flows ranging from $4.5 billion per year at $3 copper to over $11 billion per year at $5 of copper.”

Based on today’s copper price of $3.64, Freeport can roughly project $9 billion in earnings (EBITDA) and $6.45 billion in operating cash flow.

Freeport’s current share price presents an opportunity because the stock has pulled back a bit with the price of copper and concern about global growth. Freeport is a well-run company with a return on equity of 27%, return on assets of 12%, and has an ample cash reserve of $9.5 billion.

Freeport is trading right at 30 per share, down from March 2022 high of 52 with a valuation of just under 10X earnings. I think we have more upside potential than downside risk and recommend building a half position in the stock. BUY A HALF POSITION

Model Portfolio

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Updates
Centrus Energy (LEU) shares, after an impressive run over the last few weeks, retreated to 38 on some profit taking. The company recently announced quarterly earnings of $2.51 per share, compared to earnings of $0.79 per share a year ago. Based in Bethesda, Maryland, Centrus supplies nuclear fuel and services for the global nuclear power industry.

The nuclear power industry is anticipating a new generation of advanced reactors under development. Centrus provides an integrated solution for meeting the industry’s engineering, manufacturing and fuel needs. The United States has 94 reactors that generate about 20% of our electricity but we have not built one new plant in the last 25 years. Centrus stock is still trading way off its 52-week high and at just under four times earnings. BUY A HALF

Cloudflare (NET) shares were up 39% last week after the company reported second-quarter earnings, but this week the stock pulled back from 79 to 75. Its revenue rose 54% year over year to $234.5 million. Cloudflare offers free services to anyone, but it makes around 60% of its revenue from large customers spending at least $100,000 annually. That’s good news, because these large customers are much less likely to go through the pains of switching providers. Cloudflare gained a record 212 new large customers in the second quarter.

Cloudflare consistently delivers impressive revenue results and has the potential for steady growth. I still believe this is a buy since it is still down more than 40% from its 2022 high. BUY A HALF

CVS Health Corporation (CVS) shares were up marginally this week to reach 105 following an 11% increase in second-quarter sales. It was reported that CVS plans on submitting a bid for Signify.

Signify conducts in-home health evaluations and has a market value of less than $7 billion. CVS could potentially buy the company in cash, because as of June it has a cash balance total of $12.5 billion. The company also hinted that it could be getting into the primary care business before the end of 2022. CVS Health’s earnings per share has grown 26% each year, compounded, over the past three years. BUY A HALF

Fanuc (FANUY) shares were steady this again this week and it is a bit frustrating given the company’s strengths. This sleep-well-at-night company and stock is the world’s leading manufacturer of computerized numerical control (CNC) devices that are used in machine tools and also serve as the “brains” of industrial robots. Fanuc offers us a high-quality stock that should be firm with its strong balance sheet and plenty of cash. Fanuc is a play on a clear industrial robotics growth trend and my six-month price target for this low-risk stock remains 25. BUY A HALF

Ford (F) shares were up over 16 this week as the company issued $1.75 billion in green bond financing that would fund clean transportation projects, including the design, development and manufacturing of electric vehicles in North America. This includes next-generation electric F-150 pickups and other vehicles that have yet to be announced.

July U.S. sales climbed 37% and Ford had a 70% bounce in SUV sales while U.S. sales of trucks, which made up just over half of Ford’s U.S. monthly sales, climbed about 20%. Ford plans to reopen its F-150 Lightning electric truck for new orders but will charge significantly higher prices on the vehicle in order to offset increased input costs caused by inflation.

Ford stock still stands out for its value as it trades at just five times trailing earnings. I encourage you to buy if you have not already done so. BUY A HALF

Infineon Technologies (IFNNY) shares were off 4% this week after the company recently posted its latest quarterly results, with 33% revenue growth, and increased its revenue forecast thanks to auto-industry demand.

This is in contrast to AMD and other semiconductor companies focused on struggling markets such as computer laptops and cell phones. This is why it’s better to be in the business of auto-focused chips, which should continue to be a good market despite supply shortages.

Infineon is a leading broad-based European chipmaker with exposure to secular growth drivers in the industrial and automotive chip sectors. Infineon was founded when the company was divided from its Siemens parent in 1999. The stock is still trading at a discount to its intrinsic value. BUY A HALF

MP Materials (MP) shares pulled back from 39 to 36 this week after being up 12% in their first week as an Explorer recommendation. The company reported adjusted earnings per share (EPS) surging 139% from the prior-year quarter’s levels and generated revenues of $144 million in the second quarter of 2022, reflecting a year-over-year jump of 96%.

MP is a fundamental way to play clean tech, defense, semiconductors and other advanced and emerging technologies through some of their basic inputs – rare earths. Right now MP has to send its metals to refineries in China. But that’s going to change as the company plans to develop domestic refining capability. Earlier this year the Department of Defense gave MP a $35 million contract to refine heavy rare earth elements at the company’s site in Mountain Pass, California. BUY A HALF

Oracle Corporation (ORCL) shares were up two points this week as the company builds out a renewal of a strategic agreement with AT&T that will help give new capacity and capabilities for the company’s database and application workloads running in Oracle Cloud. Oracle and Microsoft recently announced a deeper cooperation of their clouds, allowing customers to more easily run projects across both platforms. Oracle is a conservative company with a decent dividend and has historically been one of the safest stocks in software. We will keep it a hold for now. HOLD A HALF

Sociedad Química y Minera de Chile S.A. (SQM) shares will likely open around 100 this morning as yesterday the company reported a another strong quarter. SQM’s earnings for the second quarter were US$859.3 million (US$3.01 per share), an increase of 857% compared to US$89.8 million (US$0.31 per share) for the second quarter of 2021. Gross profit for the second quarter of 2022 reached US$1.29 billion, 598% higher than the US$185.9 million recorded in the second quarter of 2021.

Revenues totaled US$2.59 billion for the second quarter 2022, an increase of approximately 342% compared to US$588 million for the second quarter of 2021.

The challenge will be for the next quarter to keep pace with the company’s latest quarter. The company is also the largest producer of potassium nitrate, used for fertilizer, so SQM is seen as a fertilizer and lithium play. HOLD A HALF

The next Cabot Explorer issue will be published on September 1, 2022.

JUST PUBLISHED — New book from Chief Analyst Carl Delfeld

Analyst Bio

Carl Delfeld

Carl Delfeld is a member of the Cabot investment team, and chief analyst of Cabot Explorer.

He received his Masters in Law and Diplomacy at the Tufts Fletcher School; worked for the First National Bank of Boston (now Bank of America) in London, serving as director of the Japan and South Korea Group; served as vice president at the investment bank Robert W. Baird & Company, developing new business in Tokyo, Hong Kong and Sydney; was Asia advisor to the U.S. Congressional Joint Economic Committee, the U.S. Finance Committee and the U.S. Department of the Treasury; wrote for Forbes Asia and the Far Eastern Economic Review; served as a member on the U.S. National Committee on Pacific Economic Cooperation and the Japan-U.S. Friendship Commission; was chairman of the Asian Pension Forum and wrote a book, titled, Red, White & Bold; the New American Century.