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Freeport-McMoRan: A Lesson In Listening To The Model

Summary After I designed a model that was surprisingly effective at predicting movements in Freeport-McMoRan, I stopped listening to it. The model was clearly predicting the latest crashes in Freeport-McMoRan. As bad as things are for Freeport-McMoRan, the commodities suggest current pricing is pretty fair. Freeport-McMoRan (NYSE: FCX ) has been in freefall for the last month or so. There have been great opportunities to get out, but I missed them because I was focused on doing analysis on other parts of the market. This is a story of the massive mistake I made and how easily it could have been prevented. Predicting Commodity Prices From the start, I’ve said that my goal is not to predict commodity prices because predicting which way the prices will move is not within my skill set. When I make investing decisions, I want to be functioning within my area of expertise. When it comes to Freeport-McMoRan my area of expertise was building a model that was vastly better at predicting returns than I could be relying on any other tool. Despite knowing that my area of expertise was in building the model, I allowed myself to be swamped with work and didn’t return to regularly run my model the way I did during my first stint investing in Freeport-McMoRan. How I Should Have Done It The best method for me would have been to write it into my schedule that at least every week I had to completely rerun my model and decide if the stock was worthy of investment at that point given the results. Unfortunately, I didn’t do that. I ran the model around June 7th, decided it was getting risky and posted my downgrade and intent to keep running the model and watching for strong indicators to get out. The proper choice, clearly, would have been to sell out immediately rather than looking to get a tiny bit of extra return relative to my index by holding the position. Let this be a lesson to all investors to keep a close eye on those volatile investments. At the same time, it would have been wise for me to make some improvements to make the model easier to update. That may have encouraged me to keep checking it every day rather than allowing my early summer days to become swamped with other activities. I’ve taken both of those lessons to heart. The saddest irony, as you’ll see, is that the spread widened further, precisely as I predicted over the next couple weeks. Part of that time was when I was out of the state and away from my model. Clearly, I should have closed out the position before I left. Getting Up to Date I reran my model which uses the opening values for shares of Freeport-McMoRan along with the opening values for different ETFs that track 4 of the 5 commodities Freeport-McMoRan produces. I use those ETFs to track the estimated price change in futures contracts on the commodities as a way of seeing where commodity prices are going. Occasionally Freeport-McMoRan will move before the futures prices on the commodities but a large divergence has been a clear sign that a correction is coming. In using those commodities I built my model to predict average annual EBITDA for FCX over the next couple of years and then set a standard deduction from that value to estimate the other necessary cost implications because interest, depreciation and amortization are very real costs. Taxes is also a real cost, but will generally scale in such a way that it is automatically accounted for in my model. That should sound very complex to readers that didn’t see my previous work on Freeport-McMoRan, but the charts are easy enough to read. The chart below shows the values for EBITDA minus the static. As you can see, the lines show a very strong connection. (click to enlarge) While I like that method for looking at the correlation over the long term, I prefer to actually read the output using bar charts. The following chart shows the values for the last seven months: (click to enlarge) I designed these charts using the opening values for each ticker. We don’t have the opening value for Monday, so I inserted the closing prices for Friday, July 24th as “July 25th”. As you can see, over the last couple months the shares have fallen significantly but not by near as much as the expected earnings. Contrary to popular belief, Freeport-McMoRan stock was actually holding up well if we compare it to the fundamental earning power of the company. You may notice the left side of the chart is done in percentage terms. I standardized all the values in that chart based off the values from the start of 2014. There is no reason to think that the values from the start of 2014 were perfectly aligned, but it made it possible to reliably get both bars onto the same scale to compare relative strength. Relative Strength I put together another chart that makes it even easier to read. This chart standardizes based off percentage change from the values on May 20th. (click to enlarge) Had I been disciplined enough to force myself to update the spreadsheet more regularly, I would have been out without a problem. I’m providing an even larger version of the very clear “Get the **** out” signal: By the middle of June the model was sending off extremely strong sell signals. When I tried to do an eyeball test of the movement by simply looking at price charts in early July, I thought the commodities were moving before Freeport-McMoRan and started to doubt my model. If I had updated it completely, I would have seen that Freeport-McMoRan was simply catching up with the losses the model was predicting and I would’ve got the heck out. What Does It All Mean for Freeport-McMoRan? Based on my model, the closing values put us fairly close to fairly priced. That makes decisions to buy or sell fairly neutral. The biggest concern on buying is that the volatility is enormous. I’ll be putting in some work to make the model easier for me to update and then I’ll be watching for another one of those clear buying or selling signals. At the moment the model is quite neutral since the red line is only mildly taller than the blue. This wasn’t a case of my model failing me, it was me failing the model and paying dearly for it. I designed my system around having an index of ETFs that I could use as my benchmark. This is the same batch of ETFs that I use in estimating EBITDA based off commodity futures contracts. Relative to the benchmark, I’m “winning”. The benchmark is down 52.4% and FCX is down 48.4%. Somehow, this doesn’t feel like winning. Disclosure: I am/we are long FCX. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article. Additional disclosure: Information in this article represents the opinion of the analyst. All statements are represented as opinions, rather than facts, and should not be construed as advice to buy or sell a security. Ratings of “outperform” and “underperform” reflect the analyst’s estimation of a divergence between the market value for a security and the price that would be appropriate given the potential for risks and returns relative to other securities. The analyst does not know your particular objectives for returns or constraints upon investing. All investors are encouraged to do their own research before making any investment decision. Information is regularly obtained from Yahoo Finance, Google Finance, and SEC Database. If Yahoo, Google, or the SEC database contained faulty or old information it could be incorporated into my analysis.

Meet 5 IBD 50 Stocks Reporting Earnings This Week

Earnings season has kicked into high gear, and a number of top-rated stocks such as Vasco Data Security (VDSI) and Facebook (FB) are due to report earnings this coming week. The computer-generated IBD 50 list of premier stocks is based on a combination of each company’s recent profit growth record, its IBD Composite Rating and its price performance over the last 12 months. Today’s IBD 50 list includes five top-rated tech-related stocks that are

Here’s Why I Am Staying Away From California Water Service Group

Summary California Water Service Group is a water utility serving California, Washington, New Mexico and Hawaii. California Water Service Group generated free cash flow in only two of the past 19 years. California Water Service Group possesses a high amount of long-term debt. It’s important for long-term investors to develop a guide for doing their investment research. Over the years, I have developed questions to guide me in my thinking when researching the publicly traded universe. Today, let’s talk about California Water Service Group (NYSE: CWT ). 1.) What does the company do? When you buy shares in a company you effectively become part owner of that company. Therefore, it’s important for an investor to understand what a company sells. California Water Service Group sells water. The company operates mainly on the west coast in states such as California, Washington, New Mexico and Hawaii. It operates regulated and non-regulated businesses. 2.) What do the fundamentals look like? Investors should also look for companies that grow revenue and free cash flow over the long term, retaining some of that cash for reinvestment back into the business and for economic hard times. Excellent revenue and free cash flow growth serve as catalysts for superior long-term gains. California Water Service Group expanded its revenue and net income 32% and 63%, respectively, over the past five years (see chart below). CWT Revenue (TTM) data by YCharts California Water Service Group operates in a highly regulated business which constrains operations. Also, drought conditions make operating a water utility difficult. Moreover, the company has only been free cash flow positive in two of the past 10 years, according to Morningstar. Large amounts of capital expenditures exceed operating cash flow due to the capital intensive nature of the business. Capital maintenance of this nature leaves little room for expansion and tangible capital returns to shareholders in the form of dividends, which can contribute heavily to any stock market return. I like to see companies expand their free cash flow over the long term. This gives an indication that a company can stand on its own two feet. California Water Service Group sports a lousy balance sheet by my standards. In the most recent quarter, the company possessed $33.3 million in cash and equivalents, which equates to a mere 5.4% of stockholders’ equity. I always like to see companies with cash amounting to 20% or more of stockholders’ equity to get them through tough times. California Water Service Group’s long-term debt amounts to 68% of stockholders’ equity. I like to see companies keep long-term debt at 50% of stockholders’ equity or less. Operating income only exceeded interest expense by three times in FY 2014. The rule of thumb for safety lies at five times or more. Like most utilities, California Water Service Group does pay a dividend. However, its dividend sustainability doesn’t hold water. I like to see companies pay out less than 50% of their full-year free cash flow in dividends, retaining the remainder for other things. Last year, California Water Service Group ran a free cash flow deficit, meaning that the dividend came from sources other than free cash flow. Currently, the company pays its shareholders $0.67 per share per year and yields 2.9% annually. California Water Service Group’s sub-par fundamentals only translated into 48% total return for the company’s shareholders vs. 114% for the S&P 500 as a whole (chart below). CWT Total Return Price data by YCharts 3.) How much management-employee ownership is there? Investors should always look for businesses where the managers and/or employees own a lot of stock in the company. Managers with a great deal of stock in the company will take better care to maximize company profits, which will enhance share price and their personal wealth along with the wealth of shareholders. According to California Water Service Group, company executives each own less than 1% of the company’s stock. This isn’t too big of a deal, this just mean that management lacks the extra incentive provided by huge ownership of the company. 4.) How does its “Report of Independent Registered Public Accounting Firm” stack up? Every year a company employs external auditors to audit financial statements and evaluate whether the company maintains adequate financial controls. At the conclusion of the audit, you want to see a letter from auditors with the language “unqualified” or “fairly presents”, which generally means that the financial statements and internal systems in constructing them were clean or adequate. If you see “qualified” or “adverse” in the auditing letter’s language, then deeper issues in a company’s financial statements may exist. According to California Water Service Group’s latest auditing statement, the financial statements were presented fairly and the company maintained adequate internal controls. 5.) What types of risk does it have? It’s always important for investors to weigh the various risks such as exposure to political risk in parts of the world where war is the norm, competitive positioning, and market price risk. California Water Service Group operates exclusively in the United States, which means political risk resides in the minimum range. California Water Service Group represents an infrastructure stock, meaning there is little or no competition in its service area. The barriers to entry reside in the high range due to regulatory and capital hurdles to entering the business. However, drought conditions could increase regulatory scrutiny and the introduction of more exotic accounting. California Water Service Group’s market price risk actually resides in the low range. The company’s P/E ratio clocks in at 18 vs. 19 for the S&P 500 as a whole, according to Morningstar. 6.) What does its forward analysis look like? Just because California Water Service Group is a needed water utility doesn’t mean that it’s risk free. I prefer to see companies generate free cash flow on their own and possess a margin of safety in terms of interest cost coverage. Regulatory conditions combined with high capital maintenance will make it difficult for the company to generate free cash flow, which represents the life blood of things like superior capital gains and dividend increases. I am keeping my investment dollars away from this company. Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More…) I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.