Strong commodity prices offer a good exit point.
Known Unknowns
I usually stay away from resource companies. Or, more accurately, I stay away from the exploration and production companies. Service companies I like; the ones that sell the shovels to the prospectors. Those are businesses I can understand. But exploration and production companies leave me scratching my head. Exploration companies seem particularly opaque. Maybe if I was a geologist, I could approach the sector with some level of discernment but as it is I’d just be flying blind. The colourful maps in the investor presentations are cool, but I have no idea how to interpret them. I’d be better off buying myself a few lottery tickets.
Producers are more grounded and lend themselves somewhat more to a traditional value analysis. But here too, I usually find there are too many imponderables. With a regular operating company, you can usually make a reasonable estimate of future profitability based on past behaviour. But with a resource production company, that’s often not the case.
Instead, the future price of the commodity in question often becomes the defining characteristic of the investment. Whether a gold mining stock is a success or a failure has a lot more to do with the future price of gold than it does with the individual merits of the company under scrutiny. And I have no idea what the future price of gold is going to be.
There are other unknowables at play as well. What will the grade of ore be that the company mines next quarter or next year? How long will the mine last? Will they discover a rich new mineral vein that keeps them in business for another 10 years or will their reserves peter out a few years down the road? If they are operating in a foreign jurisdiction will new regulations or tax laws bring an abrupt end to operations?
So I usually just ignore the sector. There are plenty of other companies in other sectors to focus on. But every once in awhile, a company comes along that just looks too cheap to ignore. That was the case last summer with Teck Resources.
I bought into Teck Resources in June 2020 at a price of $13.30 per share. At that price, the company was trading at 3 times its peak earnings of 2 years earlier. They had a very long-lived metallurgical coal deposit in British Columbia that was cranking out reasonably reliable, albeit volatile, profits year in and year out. They also had some copper and zinc mines to offer some diversification. The icing on the cake was their new project in Chile where they were building a big new copper mine, one with a similarly long mine life that could provide a nice boost to future earnings. With the rise of electric cars and predictions of future shortages of copper, I thought there was enough certainty here at the very low price I was buying in at to justify the investment.
Fast forward a little over a year and the stock has done well by me. The share price recently climbed over $30 and I started to wonder if I should maybe cash in my chips.
The price of both copper and coking coal have come back strongly from the lows they hit during the worst of the pandemic. At current prices, Teck is raking in the cash. A lot of the big price gains in coal have come in the last few months, so we aren’t seeing the full effect of this yet in their numbers but when Q3 numbers come out in November they are likely to be strong. My guess is that by Q3 or Q4 profits will be back to previous highs or even above.
The stock price too is back to the highs it was at several years ago. As such, it may have already priced in these robust commodity prices. With investing, the trick is always to look ahead. Sometimes I fall victim to looking too far ahead and I bail out of a good idea too soon. That may be the case here as well and I may end up wishing I had stayed in for the full ride.
But looking beyond the next 6 months, into 2022, I wonder if perhaps commodity prices will settle back down a bit. Just as we saw with the recent mind-boggling spike and then collapse in the price of lumber, I start to worry if coal and copper prices might cool off somewhat as the covid pandemic settles down, mines resume normal operations, supply bottlenecks are resolved and the world gets back to business as usual.
As I said, I don’t like owning resource production companies. I don’t like having to read the tea leaves and make predictions of future commodity prices because I’m no good at it. So my bias is going to be to sell out sooner rather than later.
There are other negatives that have me eyeing the exit. Teck has taken on an awful lot of debt to build this new Chilean copper mine. Even using optimistic earnings assumptions, debt is definitely more than the 3 times earnings I usually set as my maximum.
As well, the company is facing ongoing problems with water pollution at its core coal mining facilities in BC. The government is on their case and they are having to spend hundreds of millions of dollars to try to clean up their operations. I worry they may not be completely successful.
Another worm in the apple is the election of a new socialist government in Peru where they have one of their main copper mines currently. This mine is contributing a fair bit to their overall profitability right now and the new Peruvian government is eyeing the profits of all the foreign mining companies in the country. They may not come right out and nationalize these mines, but they might claim a much bigger chunk of their profits in tax. Worst case scenario, a big tax hike could go a long way towards negating the positive contribution from the new Chilean mine.
All things considered, I’ll take the gain I’ve made to date on Teck and be happy with that. I sold my Teck Resources this morning and will add this to the cash I raised from the Cervus Equipment sale. I’m deep in the middle of a second quarter review and these two sales will give me the firepower to take advantage of any new investments I find.
Full Disclosure: I do not own any shares in Teck Resources.