And that's the essential logic behind my purchase of 2,770 shares at 787.5p a piece in copper producer Antofagasta (ANTO) for the Bearbull Income Portfolio. Of course, there is a bit of detail, too, so let's start with the reasons why an investor should be reluctant to put capital into Antofagasta's shares; relegate those to a side issue and the case for buying becomes more plausible.
The background concern is that the global commodity boom is over. It served miners wonderfully well for much of the 'noughties', but now that growth in China is less frenzied and sustained growth throughout the developing world no longer a given, then that boom is over. Meanwhile, the natural - though delayed - response to higher prices is more production, which may mean that global copper output exceeds demand, letting prices slip further. A surplus was expected in 2013 - but did not materialise - and looks more likely this year. Link these bearish factors to rising cost pressures and the profitability of copper producers looks seriously undermined.
In Antofagasta's case, the Chilean miner grapples with all those factors. In 2013, its growth in output slowed to a crawl - up just 1.6 per cent to 721,000 tonnes compared with average growth of 17 per cent in the three previous years - and its bosses expect output to fall a touch in 2014. Simultaneously, costs made a step change - up 32 per cent in 2013 to $1.36 to produce a pound of copper, and at Antofagasta's second-biggest mine, Esperanza, costs seemed hopelessly out of control, more than doubling to $1.43. Costs are expected to rise again in 2014, but at a much more sedate 6 per cent. In the longer term, Antofagasta will add to global output, with aggressive expansion plans that could add almost 200,000 tonnes of copper - or approaching 30 per cent - to its annual output by 2018.
But the twin squeeze of downward prices and upward costs will make profit margins less ample rather than skinny. Even though Antofagasta's margin of cash profits (so-called 'ebitda') to sales dropped 12 percentage points in 2013, it was still 45 per cent. So the extra production the group may push onto an indifferent global market will hurt less profitable miners the most.
True, there will be $3bn of capital costs associated with the production uplift. That's about equal to an average year's cash profits, so it sounds a lot. Yet, on the basis of current copper prices, the extra production would repay its capital outlay in little more than two years. And even after factoring in production costs and tax, the net payback could well be within seven years - a quick enough pay-off for projects whose lives are likely to be at least twice that length.
Working down to the nitty gritty of guesstimating a value for Antofagasta's shares, it's feasible to come up with figures well clear of the current share price. For example, capitalise average operating profits for the past five years based on a cost of equity of 8.5 per cent and net cost of Antofagasta's insignificant amount of debt of about 2.8 per cent and Bearbull's model comes up with a per share value of 975p.
That's after deducting the substantial minority interests in its mines as well as its debt, yet it is before adding in perhaps $2.6bn of surplus cash that the group carries. Some of that cash may get sucked up by heavy capital spending, so it may be safest to ignore it. Related to that, capitalising average levels of free cash flow (the cash profit left over for shareholders) for the past five years generates a lower value than capitalising operating profits - about 644p a share. That reflects the fact that, in the past five years, Antofagasta's capital spending (which is deducted against free cash) has been almost three times depreciation (a charge against operating profits).
Still, all that excess capital spending should have a present value, too (if it doesn't, why spend it?). The difficulty is that estimating it requires major assumptions such that the figures range from 140p per share to above £4. The key point, however, is that the full cash-flow valuation exercise (valuing both free cash flow and excess capital spending) produces a figure clear of the current share price even on the most cautious assumptions, and - without abandoning common sense - can generate a value that leaves £10 behind.
Granted, there is uncertainty surrounding the level of Antofagasta's future dividends. I discussed this issue in my previous thoughts on Antofagasta (Bearbull, 2 May 2014), but it means that the shares may fail to generate the income needed for a high-yield fund. Meanwhile, the shares are closely linked to the copper price and are deeply unpopular. Yet that's where we came in and I hardly have to remind readers that buying shares is not about picking the winners of a popularity contest, but picking winners of business life at attractive prices. Antofagasta seems to fit that bill.
