While my statement from the headline might sound as obvious as brushing teeth each day, there are indeed also proponents of buying shares of companies that have among the worst economics – not the best. This is then justified by a higher operating leverage, should commodity prices rise, due to then disproportionately higher improvements in the financial statements. Here’s what you should know.

Summary and key takeaways from today’s Weekly
– While it might be tempting to buy commodity stocks that are in trouble for the largest upside, I think this is the wrong approach, because it is highly risky.
– Should the upswing take longer than expected, you can suffer huge losses.
– Companies with low production costs have clear advantages and are the better pick from a risk management perspective.

It might sound tempting and be itching in the fingers for a more risk-seeking investor to not buy stock in a low-cost, but in a high-cost commodity producer.

Especially, if a rise in the respective commodity price is expected.

The reasoning can sound something like this: The former (low-cost) has higher margins and less potential for increasing them percentage-wise, while the latter (high-cost) has more room for improvement and for a strong comeback, due to its financials making higher leaps forward disproportionately in the event of a successful turnaround, maybe even coming from loss-making results.

I think both arguments are right, if only taken at face value.

This “turnaround game” can be rewarding on a grand scale, if played successfully. It can be seen as additional leverage on an anyhow leveraged bet, as commodity stocks are most often already showing disproportionate moves to their underlying commodities (not always, but when looking at a longer, more general trend).

So why not pick the spiciest stock for a potential home run?

Most of my readers will already have the answer on their tongue. It’s risk management.

I have already explained here and there in my free Weeklies, but also in some of my exclusive research reports for my members that I clearly prefer the “safety first” approach, before stumbling into a disaster. Even worse are bets where you have the time against you, i.e. depending on a quick tilt in your favor.

Isn’t it better to be on the safer side, waiting for your thesis to materialize?

This does not mean that there are entirely no risks. But I focus pretty much on avoiding the truly obvious and easiest to circumvent pitfalls which often are a too high debt load and weak business economics in the form of high costs and low margins.

In the end, my goal is not to have a basket of 1,000 stocks at a time, but to only deal with those ideas I deem as high quality and where I feel convinced.

In today’s Weekly, I am going to show you some thoughts and calculations you should be aware of when considering to play such games. It is up to each individual to buy those stocks where the risk appetite allows for it.

But I don’t need it.

By the way, my next stock idea, exclusively for my Premium and Premium PLUS members, features such a company. It is one of the most profitable in its peer group due to having ultra-low costs. There was some uncertainty, especially around the dividend policy. A hefty dividend cut from blockbuster levels was safe to come.

But now, we have more clarity – I estimate the annualized dividend yield will be something around 10–15%, easily covered by free cash flows – so that I think it is time for a new report which I am going to publish next Saturday, 12 August 2023.

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Some basic math you should understand

As said, while you certainly can hit the jackpot even with an ugly business, just being at the right place at the right time and benefiting from higher commodity prices in the sense of “the tide lifts all boats”, this is not my personal approach.

There is just too much that can go wrong and there’s dependence on luck.

Keep in mind that it is better to have time on your side, not against you.

What I learnt over the years and appreciate since is that you should not only see the blue sky scenarios, but first and foremost the risks.

If you assess the risks and deem them either as realistically (!) manageable or maybe only with low damage potential, then everything’s fine.

But what you don’t want to have is either a:

• low probability risk, however with a potentially devastating outcome if it were to happen
• complete dependency on factors outside of the business’s scope of action without an adequate margin of safety (while commodity producers of course are dependent on the price of the respective resource, you can avoid other pitfalls like high production costs and / or high debt or risk of shareholder dilution at low share prices)
• time ticking against you as either a too high debt load becomes due or cash is running out, increasing the need for stockholder-unfriendly refinancing (either debt or share dilution – or even both in combination)

And such risky bets are by no means “heads, I win, tails I don’t lose” bets.

To the contrary. Should the assumption of higher commodity prices either be completely wrong or just the timing – meaning it takes way longer than thought – it can become really costly.

Remember bear markets that didn’t want to end? Energy from 2014 to 2020 or gold from 1980 to 1999 and 2011 to also c. 2020?

Just think of the goldbugs preaching and throwing around perseverance slogans during all the 2010s while many gold miners were terrible investments at the wrong time. Likewise, you did better with oil producers that were able to still pay dividends thanks to low production costs and healthier balance sheets during the bear market while others were busy surviving.

It is better to own stock in a high quality business and then just lose 20% if you’re wrong and quit, while the stock of a mediocre business and with financial problems could easily fall double or triple of that.

And with this, let’s have a look at why cost structures are of such a significant importance, especially in terms of risk management.

I am going to illustrate my point with a few simple calculations and charts.

The input data I am using for my models are the following:

• realized sales prices of 35 USD, 25 USD and 15 USD – one price for each scenario and the only actively changing variable that influences the rest
• three companies “good”, “average” and “bad”, each with different production costs of 10 USD, 15 USD and 20 USD
• the resulting margins and profits or losses

But I am starting with the “blue sky” scenario first to show you what could go wrong, as this is key for a risk-oriented investor.

The most obvious result is that all companies are profitable, even highly.

Not a surprise.

However, this scenario is perfect to hide operational problems, especially among the weaker businesses (that’s why the tide lifts all boats) and to shift the focus from operational excellence to doing silly stuff, as margins are high and profits abundant.

But wouldn’t it be wiser and more calming to own the “good” company?

It has the highest margins and thus the highest relative cash flows. This allows for better shareholder distributions, but also debt repayments or acquisitions. And likely, due to the higher cash flows, this company should have the highest valuation multiple.

Of course, high cash flows can be used to do silly things, either, like too expensive takeovers for low-quality at the top of the cycle. To the contrary, it is also possible that high quality companies with higher valuations can use their own expensive stock to buy competitors at minimal dilution.

In the end, the flexibility is the highest.

Now scenario 2 with average realized sales of 25 USD:

While at first sight nothing dramatic seems to have happened with the exception of lower profits, if you look closer, you will see that the differences are already vast.

The “good” company had margins of 71% in scenario 1 and now they fell to 60%. A luxury problem. That’s like a small rounding error compared to what happened to the others, because the “bad” company in the blue sky scenario had margins of 43% which now collapsed to 20% (they more than halved!)– while the price of the commodity fell by 29%

In other words, what is expected to be a disproportionate gain in a bull market, likewise works to the downside – in reverse. The weakest competitors suffer the most. At the same time, the lowest-cost producers have some sort of an airbag attached to them, because they fall slower operationally.

Now scenario 3 where the sector gets stress-tested:

Uff, at average realized sales prices for the commodity of just 15 USD, you can see the issues. While the “good” company is still profitable (but its share price likely also down massively), the “average” business does not make any profit, while the “bad” producer is deep in the red.

And this can really hurt now in several ways.

The basic idea was to buy such distressed companies, because they have a perceived higher upside potential due to their financials improving disproportionately in the case of a bull market.

While this is true, the right question would rather be: What if the bull market comes way later?

The important thing to realize and understand is that near the bottom of a brutal bear market more brutal things can happen.

It is by no means only limited to a lower stock price.

Consider the following:

• It can go as far as weak competitors get forced to massively dilute their shareholders by raising fresh equity at low stock prices, because they are not cost-competitive and loss making
• this dilution not only lets the share price drop massively and immediately as the dilution is high, it also limits your upside for the bull market
• in the case of debt instead of equity (if successfully placed, which is not safe), then the stock will also suffer, because the business will have to pay debt holders instead of rewarding shareholders
• should the price of the commodity make a final brutal dip, stocks of weaker companies will suffer even higher losses, forcing them to decrease production volumes or even to completely stop producing at all
• depending on the commodity it can take months to restart production again. An ill-timed closure can make the business sitting on the sidelines watching the price of the commodity going up while no or less sales are made than potentially possible

At the same time, the lowest-cost producer will gain market share!

And / or gobble up competitors.

Do you know the difference between a stock that has fallen by 80% and one that has fallen by 90%? – it’s 50% (not 10%, as the remaining value falls from 20% to 10%, i.e. it halves).

While the framed above might read like a joke, you should have understood the message. A stock that has fallen massively is not automatically immune to falling by another 30%, 50% or yet even another 80%. Worse things can happen after bad ones.

You want to stay away from such trouble.

If commodity prices fall too low – like it happened in uranium for instance – then many or even the majority of producers stop their operations, because they are not profitable.

You definitely want to own the low-cost producers then, because they not only survive the bear market better, as they can participate to the upside in full swing or with the least damage.

That’s why I picked a low-cost energy (mainly oil) producer for my next research report.

This way, you don’t have to mind too much whether the price of oil in this case falls.

Of course, the business results as well as the stock price will fluctuate. But this company will be one of the latest to be in trouble. It is more likely that high-cost competitors will have reduced their production and thus overall supply, which is price-supportive.

Also the company’s debt is finally under control (which wasn’t the case in the past) and dilution is unlikely. Last year, it paid unimaginably high dividends. In the past months, it was clear that this will not continue this way. The question was, how high will the cut and thus the remaining payout be?

We now have the answer.

My conservative estimates are that the dividend yield – at prices of Brent oil around 80 USD – will be at least 10%. 15% are also possible and even realistic.

I explain everything you need to know in my next report, due next Saturday 12 August 2023.

Conclusion

While it might be tempting to buy commodity stocks that are in trouble for the largest upside, I think this is the wrong approach, because it is highly risky.

Should the upswing take longer than expected, you can suffer huge losses.

Companies with low production costs have clear advantages and are the better pick from a risk management perspective.