Morningstar Advisor - December/January 2012 - (Page 30)

Sector Rap basic materials in general and all the different commodities as a way to play on global economic fears. A lot of the steel companies that I cover are down 40%–60% just since July, even though not a lot has changed with steel fundamentals. Guziec: So, Vale’s shares are pricing in, basically, a 100% chance of a fairly deep recession. Freas: Right. And even if we were to go back to consumption levels in line with 2009, I think most of the companies that I cover are in a much better position this time to navigate that environment. Collins: We have to treat gold as its own industry, even though it belongs in the metals and mining industry. But there are some interesting phenomena going on with gold. Guziec: I’ve heard a little about that. (laughter) Collins: Gold prices have been very strong this year until very recently. There’s been a recent downturn in gold prices; I think that’s been because gold has actually been acting just as promised by gold bugs: It’s acting as a source of liquidity when people are facing redemptions and margins calls and things of that nature. is issue gold-price-linked dividends that will change in tandem with gold-price changes. It gives investors income, which gold-backed ETFs do not; and it gives more-direct leverage to gold prices than the whims of the market in terms of gold-mining shares’ depreciation or appreciation. It is a bit risky because, if a company links their dividend to gold prices without some release valves for cost pressures or production disruptions, they could be a position where they promise to pay out a certain dividend level, but it would actually hurt their financial health if they’re suffering from high costs of reduced production. But a dividend is not a contract, it’s more of a promise that gets voted on. From Morningstar’s perspective, it’s a really good idea because gold-price-linked dividends give companies less available cash at good times, and they give companies a source of cash during tough times when their operations are throwing off less cash. I mentioned the several reasons that gold companies have lost ground against gold prices; I forgot to mention gold-price expectations. That’s one of the easiest explanations—it’s likely that equity valuations incorporate long-term gold prices nearer to $1,100 an ounce versus the $1,700 an ounce that we’re seeing today. Joung Park: And mining executives are even demand factors. But sometimes the market, in times of uncertainty, can be more nearsighted. And when you see cyclical concerns topping favorable long-term trends, that’s when you have more investing opportunities. Guziec: Can we identify any companies in basic materials that have economic moats and aren’t subject to as much cyclicality or as much risk to the underlying valuation? Collins: We talked about thermal coal earlier, and Cloud Peak CLD is one company we like for the long term. They have low-cost production in the Powder River Basin in Wyoming, and there’s an increasing opportunity for them to transport that to Asian markets. The market just isn’t as favorable on CloudPeak as it should be. Park: Among the gold miners we like, we like Yamana Gold AUY the best. We like Yamana because it’s somewhat of a turnaround story. It’s not getting as high of a valuation as some of the other similar gold miners; the company did have some operational issues in the past that I think were temporary because they were undergoing major acquisitions, and it takes some time to integrate such transactions. It’s not as undervalued as it had been, but we think it has some room to go. Freas: I would say ArcelorMittal MT. It’s by far the largest steel company in the world, and its scale, distribution capabilities, and operational flexibility are unmatched. But the main reason I really like it right now comes down to valuation. This is a stock that has just gotten killed in the past couple of months. Obviously it’s a stock that’s going to swing pretty hard with the economic sentiment, but if you look at the company and how it’s operating, there are a number of things that the market is sort of ignoring. For the stock to fall 60% in the past few months is unjustified. K Philip Guziec, CFA, is a derivatives strategist for Morningstar and co-editor of Morningstar OptionInvestor online newsletter and research service. Even though gold prices have been very strong this year, gold-mining equities have not performed to the same extent. There are a couple of reasons worth noting. There are higher costs, geopolitical uncertainty, and the possibility that the premium that gold miners have been awarded in the past could be going away. While gold miners used to be given a premium valuation by the market because of the role that gold-mining equities played in a diversified portfolio, now investors can go very easily to gold in the form of gold-backed ETFs. Gold miners are very concerned about that; they’re addressing it with concrete steps this year. The best thing that they can do, from our perspective, more conservative about gold-price assumptions—something like $1,000 or $900 is what they’re using for their reserves accounting. Collins: But I would argue that, in their minds, mining executives are very bullish. Guziec: Are the secular trends baked into market prices and our valuations? There’s only so much iron ore, only so much metallurgical coal … Collins: I think in general we tend to be in agreement with market participants on which industries have the most-favorable 30 Morningstar Advisor December/January 2012

Table of Contents for the Digital Edition of Morningstar Advisor - December/January 2012

Morningstar Advisor - December/January 2012
Contents
Contributors
Letter From the Editor
Seduced by Complexity
Is China Exposure Important for a Portfolio?
A Niche Built on Trust
How to Find Your Client’s Investment Style
Taking the Long View
Consensus on Europe Elusive
Four Picks for the Present
Investment Briefs
Is Perception Reality for Active Managers?
Be Alert for Basic-Materials Bargains
Investment Boom Unsustainable
Digging Moats in China
Where China’s Domestic Companies Stand to Benefit
Arising Opportunities
China Strong Long Term
From Currency Manipulation to International Acceptance
The Keys to China’s Fortune
Wedgewood’s Lessons Pay Off
Reading the Evidence on Indexing
Scouting for Investments Abroad
Yield, Please (Hold the Europe)
Mutual Fund Analyst Picks
50 Most Popular ETFs
Undervalued Stocks With Wide Moats
China Fund Managers Eat Elsewhere

Morningstar Advisor - December/January 2012