I did buy Vale shares after this analysis, arguing that there was a buffer built into earnings for further commodity price decline.
In April 2015, I revisited my valuations, as the stock prices of both companies dropped from the November 2014 levels, and I labeled the post “In search of Investment Serenity”. The post reflected the turmoil that I felt watching the market deliver a negative judgment on my initial thesis, and I wanted to check to see if the substantial changes on the ground (in commodity prices, country risk and currency levels) had not changed unalterably changed my thesis. Updating my Vale valuation, the big shifts were two fold. First, the trailing 12-month earnings that formed the basis for my expected value dropped a third from their already depressed levels six months earlier. Second, the implosion in Petrobras, the other large Brazilian commodity company, caused by a toxic combination of poor investments, large debt load and unsustainable dividends, raised my concern that Vale, a company that shares some of the same characteristics, might be Petrobrased. Again, I made the assumption that the trailing 12-month numbers reflected updated iron ore prices and revalued the company, this time removing the excess returns that I assumed in perpetuity in my earlier valuation, to arrive at a value per share of $10.71.
I concluded, with a nod towards the possibility that my conclusions were driven by my desire for confirmation bias (confirming my earlier judgment on Vale being under valued), that while I might not have been inclined to buy Vale in April 2015, I would continue to hold the stock.
Vale: The September 2015 Version
The months since my last valuation (in April 2015) have not been good for Vale, on any of the macro dimensions. The price of iron ore has continued to decline, albeit at a slower rate, over the last few months. That commodity price decline has been partially driven by the turmoil in China, a country whose massive infrastructure investments have been responsible for elevating iron ore prices over the last decade. The political risk in Brazil not only shows no signs of abating, but is feeding into concerns about economic growth and the capacity of the country to repay its debt. The run-up that we saw in Brazilian sovereign CDS prices in April 2015 has continued, with the sovereign CDS spread rising above 4.50% this week.
The ratings agencies, as always late to the party, have woken up (finally) to reassess the sovereign ratings for Brazil and have downgraded the country, Moody’s from Baa2 to Baa3 and S&P from BBB to BB+, on both a foreign and local currency basis. While both ratings changes represent only a notch in the ratings scale, the significance is that Brazil has been downgraded from investment grade status by both agencies.
Finally, Vale has updated its earnings yet again, and there seems to be no bottom in sight, with operating income dropping to $2.9 billion, a drop of more than 50% from the prior estimates. While it is true that some of the write offs that have lowered earnings are reflections of iron ore prices in the past, it is undeniable that the earnings effect of the iron ore price effect has been much larger than I estimated to be in November 2014 or April 2015. Updating my numbers, and using the sovereign CDS spread as my measure of the country default spread (since the ratings are not only in flux but don’t seem to reflect the assessment of the country today), the value per share that I get is $4.29.
I was taken aback at the changes in value over the three valuations, separated by less than a year, and attempted to look at the drivers of these changes in the chart below:
The biggest reason for the shift in value from November 2014 to April 2015 was the reassessment of earnings (accounting for 81% of my value drop), but looking at the difference between my April 2015 and September 2015 valuations, the primary culprit is the uptick in country risk, accounting for almost 61% of my loss in value.
Vale: Time to Move on?
If I stay true to my investment philosophy of investing in an asset, only if its price is less than its value, the line of no return has been passed with Vale. I am selling the stock, but I do have to tell you that it was not a decision that I made easily or without fighting through my biases. In particular, I was sorely tempted by two games:
- The “if only” game: My first instinct is to play the blame game and look for excuses for my losses. If only the Brazilian government had behaved more rationally, if only China had not collapsed, if only Vale’s earnings had been more resilient to iron ore prices, my thesis would have been right. Not only is this game completely pointless, but it eliminates any lessons that I might be extract from this fiasco.
- The “what if” game: As I worked through my valuation, I had to constantly fight the urge to pick numbers that would let me stay with my original thesis and continue to hold the stock. For instance, if I continue to use the rating to assess default spreads for Brazil, as I did in my first two valuations, the value that I get for the company is $6.65. I could have then covered up this choice with the argument that CDS markets are notorious for over reacting and that using a normalized value (either a rating-based approach or an average CDS spread over time) gives me a better estimate.
After wrestling with my own biases for an extended period, I concluded that the assumptions that I would need to make to justify continuing to hold Vale would have to be assumptions about the macro environment: that iron ore prices would stop falling and/or that the market has over reacted to Brazil’s risk woes and will correct itself. If there is anything that I have learned already from my experiences with commodity companies and country risk, it is that my macro forecasting skills are woeful and making a bet on them magically improving is wishful thinking. In fact, if I truly want to make a bet on these macro movements, there are far simpler, more direct and more lucrative ways for me to exploit these views that buying Vale; I could buy iron ore future or sell the Brazil sovereign CDS. I like Vale’s management but I think that they have been dealt a bad hand at this stage, and I am not sure that they can do much about the crosswinds that are pummeling them. If you have more faith in your macro forecasting skills than I do, it is entirely possible that Vale could be the play you want to make, if you believe that