Above the noise: Base metals stocks are oversold as PBoC eases

Base metal producers trading at huge discount
The 10 largest publicly traded base metals producers are trading 35 percent below their average EV/EBITDA since 1998 making this one of the largest "discounts" in the group's own historical valuation multiple (see chart below). This is always a good starting point for evaluating investment potential.

The main arguments for considering exposure to base metals producers right now are: the historically low valuation, China's monetary easing, growth in emerging markets, and the continuation of the commodity super cycle. We will run through all of these arguments later. But first we look at some of the big base metals producers.

Based on a sea of metrics, BHP Billiton, Rio Tinto and Freeport-McMoRan look most attractive with an average expected free cash flow yield of 20 percent! Now, just because something is trading at these "discounts" does not necessarily make it a wise investment case. For instance the valuation (based on EV/EBITDA) is not far from the observed one prior to the financial crisis. The current valuation of course reflects huge uncertainty concerning the future EBITDA levels linked directly to concerns about Europe and China's economic slowdown. I personally think markets have overshot this one and in the following outline why base metals stocks might be a good opportunity right now.

China is easing monetary policies and adds a half UK economy per year
One of the prime arguments for taking a serious look at base metals producers is the fact that China has initiated an easing cycle in its monetary policy (see chart below) through lowering the bank's reserve requirement ratio. The People's Bank of China (PBoC) has initiated its easing as Europe's economy has failed to reach economic escape velocity and domestic demand has not fully offset the pressure on exports.

As the chart above shows, China's export growth rate YoY has been rapidly declining - down towards 10 percent year on year. This has of course been a drag on base metals producers because (for as long as its economy continues to expand) China continues to be the biggest driver of demand for base metals. The Chinese trade data released over the weekend surprised to the upside and this might be evidence that exports YoY are destabilising. However, Commerce Minister Chen Deming still sees a grim outlook for trade and hopes the country can produce 10 percent growth in total trade this year.

If exports YoY stabilise at around 10 percent, combined with continued PBoC easing and the fact that China is adding a half UK economy per year (see chart below), then base metals producers should trade closer to their historical mean. A bet on base metals producers now is a bet on markets having overshot in terms of valuing metals stocks compared to global economic growth expectations. The main risk to this trade of course remains Europe's debt crisis and China's property market, which the famous short trader Jim Chanos is betting will collapse.

The commodity super-cycle is not over
A dominating theme in the last two decades has been the commodity super-cycle which has through indirect leverage in mining companies produced extraordinary total returns in the 10 largest base metals producers (see chart below) - an astonishing 19.9 percent annualised since the beginning of 1998.

Can something spectacular like this continue for another decade or two? Yes it can, and the arguments in favour of the continuation of the commodity super-cycle are developing economies' continued dramatic expansion, unstoppable weather patterns, chronic supply constraints of raw materials, an increased population base and a growing middle base. This is why last month's average 18.2 percent drop amongst the 10 base metals producers is a good entry point for adding some exposure to the commodity super-cycle. The final argument for the continuation of the super-cycle is the fact that real prices of commodities have barely moved up compared to other assets (see chart below).

Source: Pragmatic Capitalism - Commodities Super Cycle or Busting Bubble