My Pairs Trade- Long VALE And Short SCCO
Inflation is a challenging economic beast as it erodes money’s purchasing power and can become a vicious cycle where rising input prices push output prices higher. Central banks employ monetary policy tools to address inflation, but they’re most effective on the economy’s demand side. When the rising inflation comes from the supply side, central bank and monetary authority tools can be ineffective.
In the wake of the global pandemic, unprecedented central bank liquidity and the tidal wave of government stimulus planted inflationary seeds in 2020. It sprouted during the second half of that year and bloomed in 2021. In 2022, inflation spread like wildfire. The shift in US energy policy added bullish fuel to commodity prices. It handed crude oil’s pricing power back to the international oil cartel, with production and pricing policies now determined in Riyadh, Saudi Arabia, and Moscow, Russia. The US administration’s support for renewable and alternative fuels that inhibits traditional energy production lifted fossil fuel prices in 2021. The war in Ukraine, China and Russia’s “no-limits” support and a continuation of supply chain bottlenecks have poured fuel on the inflationary fire. Monetary policy tightening may not be adequate to quell inflation in the current environment as it’s a geopolitical rather than economic issue.
The shift in the US and worldwide energy policies has increased the demand for metals and minerals required for electric vehicles, wind turbines, solar panels, and other green energy initiatives when inflation is putting upward pressure on most raw materials. Commodity prices move higher in an inflationary environment, and we have seen many raw materials rise to multi-year and all-time highs in 2022.
Vale S.A. (NYSE:VALE) is a leading diversified commodity-producing company, while Southern Copper Corporation (NYSE:SCCO) produces copper and other metals and minerals. I believe the current environment favors VALE over SCCO and recommend a pairs trade that is long VALE and short SCCO.
I’m bullish on metals and minerals for at least three reasons
While metal and mineral prices have pulled back because of rising interest rates and a strong US dollar, I remain bullish on the sector as at least three factors support higher prices over the coming months and years:
- Addressing climate change will increase the demand for the metals and minerals essential for decarbonization.
- China will continue to be the leading consumer. While COVID-19 lockdowns have weighed on Chinese demand, it should come storming back in the future.
- Supplies will struggle to keep up with global requirements. It takes years, if not decades, to bring new production online, which will create deficits that increase prices.
Meanwhile, inflation is causing all production costs to increase, putting upward pressure on prices. Moreover, geopolitical bifurcation and tensions are increasing military spending, causing metal requirements to rise. Additionally, US infrastructure rebuilding will increase the demand side of the equation for many metals and minerals over the coming years.
VALE is a Brazilian mining company and a leading worldwide producer
Vale is a Brazilian multinational basic materials company. The company’s profile states:
At just below the $16 per share level on June 14, 2022, Vale’s market cap stood at the $80.35 billion level. The shares trade an average of over 31 million each day. The $1.45 per share dividend translates to a 9.12% yield.
SCCO is a South and Central American metals producer
Southern Copper is a US-based metals and mining company that operates in South and Central America. SCCO’s company profile states:
At just above the $57 level on June 14, 2022, SCCO’s market cap was $46.47 billion. The stock trades an average of over 1.26 million each day. The $5.00 dividend equates to an 8.77% yield.
Both companies have soared since the early 2020 lows
Shares of VALE and SCCO posted impressive gains since March 2020, when they fell to bottoms as the global pandemic gripped markets across all asset classes.
The chart shows VALE’s rise from $6.49 in March 2020 to the $15.85 level, a 144% gain. VALE rose to $23.18 per share in June 2021 and made a lower high of $21.29 in April 2022.
SCCO reached a bottom of $23.43 in March 2020 and was at the $57.21 level on June 14, a 144% gain over the period. SCCO rose to a high of $83.29 in May 2021 and made a lower peak at $78.18 in March 2022.
The four reasons I prefer VALE over SCCO and willing to go long the Brazilian company and short the Peruvian copper miner
Four factors lead me to favor VALE over SCCO over the coming months and years. I believe both companies will profit in the current inflationary environment where addressing climate change increases the demand for metals and minerals. VALE could have a lot more upside than SCCO.
Over the past four quarters, SCCO has missed consensus estimates in three instances while only reporting earnings in line with expectations during one quarter.
Meanwhile, VALE has had a better track record of delivering better-than-expected EPS.
VALE beat analysts’ estimates in three of the past four quarters.
- Dividends and Quant Ratings
VALE’s 9.12% yield is slightly more than SCCO’s 8.77% dividend. While both commodity producers offer far higher yields than the average, VALE’s is higher.
Seeking Alpha’s Quant Ranking for VALE is 6 out of 274 in the materials sector, and SCCO ranks 109 out of 274 in the same sector.
While the rising US dollar weighs on all commodity prices, the Brazilian real has been trending higher against the US dollar in 2022.
The chart highlights the pattern of higher lows and higher highs in the Brazilian real versus the US dollar currency relationship. A rising real increases the revenues for VALE, which is bullish for the shares. Meanwhile, this October’s Brazilian election could cause increased optimism about the Brazilian economy’s future.
Ratings on valuation, growth, profitability, momentum, and reversions favor VALE over SCCO.
VALE’s grades are above B- in all categories, with A+ ratings in valuation and profitability.
While SCCO gets an A+ in profitability, it receives a failing grade in its growth potential.
Meanwhile, a survey of 21 analysts on Yahoo Finance has an average price target of $21.22 on the shares, with forecasts ranging from $14 to $25. The average target is 33.5% above the current $15.90 share price.
The survey of five analysts on Yahoo Finance has an average target of $63.37 on the shares, with estimates ranging from $47 to $72.50. At the $57.15 level, the average target on SCCO shares is 10.88% above the current price level.
I favor a pairs trade, long VALE and short SCCO, as the prospects for VALE are far more attractive than for SCCO. I’m bullish on the sector and expect both stocks to rise, but the evidence points to far more upside potential for VALE S.A.