One my favorite investing lessons comes from Edmund Burke’s 1790 political phamphlet, "Reflections on the Revolution in France":
“Fools rush in where angels fear to tread.”
I like it because it reminds me of the value of caution and care in the selection of opportunities to which I wish to allocate my investment capital.
It pairs very well with another wise observation that most might not think to apply to investing but that I find very helpful in my own process:
“I learned that courage was not the absence of fear, but the triumph over it. The brave man is not he who does not feel afraid, but he who conquers that fear.”
- Nelson Mandela
The first reminds me to avoid rushing into decisions regarding the allocation of my capital. The second reminds me that I will always have doubts and insecurities when considering investment opportunities but, to achieve ultimate success, I must learn to overcome those insecurities and invest once I have minimized my risk through a thorough process of due diligence.
For me, investing always begins with the safety of my capital. As my regular readers already know, I really like to focus on companies providing goods or services that are necessary to the maintenance of our way of life. The main reason I have this affinity for businesses that fill this niche is I know the industry is required and that removes one aspect of risk that can completely obliterate entire industries. Just think of what the automobile did to the carriage and whip industries. Mankind still needed transportation, but it came up with a more efficient system through which to accomplish the objective.
Today I have, for your dining pleasure, an investment opportunity that not only helps provide us with a product without which we cannot survive, it works to constantly increase the efficiency with which we are able to produce that product in order to meet constantly rising demand driven by the growth in global population.
This company’s products help make it possible for a shrinking number of acres dedicated to food crops to continue to feed the world at increasingly affordable prices.
When deciding to invest, look for the best
In the investing world, there is a big difference in what a potential capital allocator might find attractive about a particular company depending on the time horizon over which they plan to hold the investment. In my own portfolio, I have holdings that cover the full range available. Some of my investments have an intended life of 30 days or less while there are others I intend to hold for years. For ultra-short term investments, I am looking to take advantage of some market anomaly I believe will be corrected very soon and which will allow me to profit from the correction. Often, these types of investments will be related to an arbitrage play related to a potential acquisition of one business by another, and I will use options to take advantage of short-term value descripencies.
For longer term investments, as initially stated, I prefer a business with necessary products or services, but I insist on a lot more than just that. I need to know that the particular business can provide me with some assurance that it will continue to survive and flourish. I also need to know that the business is poised to deliver acceptable rates of return on my capital for many years to come, and the business needs to be at least fairly valued at its current price compared to its future prospects.
Buy the biggest and best when they have a little blemish
Usually, investors expect to pay a premium price in order to own the biggest and best in a particular market segment. There are exceptions to that rule for those who are patient and willing to buy a great business when it has a little blemish. In investing, I define a “blemish” as a temporary and solvable problem that might not be pretty today but will soon be gone. I also want to see a stock price where there was a serious overreaction by the market to one of these “cosmetic defects.” A good example of this was the bribery scandal in Mexico a few years ago involving Walmart (WMT, Financial) with this type of issue. The company was accused of paying bribes to Mexican officials to further its business interest in the country. The stock price was decimated when the news broke. Yet the worst possible penalty the company faced was a miniscule portion of its annual profits.
Investors had an opportunity to buy the stock at fire sale prices for a few months. They then profited enormously as the market realized the real extent of the problem and the stock returned to its normal valuation level.
What this story means for us today
Today, I believe we have a similar but even better situation in shares of the world’s leading producer and marketer of concentrated phosphate and potash, The Mosaic Company (MOS, Financial). The business employs approximately 9,000 people in six countries and participates in every aspect of crop nutrition development.
They mine phosphate rock from nearly 200,000 acres of Mosaic-owned land in Central Florida and potash from four mines in North America, primarily in Saskatchewan. These raw products are processed into crop nutrients and then shipped to customers in agricultural centers around the world.
But, the industry in general and Mosaic in particular have had a few “blemishes” appear. These issues have caused most investors to turn away in disgust. And while the blemishes affecting the rest of the industry are fairly unattractive, Mosaic had an extra one that was specific to it and its business activities. I believe this one is what creates an extra special opportunity in the stock today as investors are about to figure out the elimination of the problem will take far less than many had feared.
The blemish on the industry
As stated above, the overall industry has been under a cloud since the Russia-based producers of potash declared war on the market when it began threatening to flood it with cheap supply back in 2013. This drove overall prices for crop nutrients through the floor and put a substantial dent in the previously significant ability of major suppliers to control market prices. I could write pages about why this was done, but it really doesn’t matter from this perspective.
Mosaic is a leader in the potash industry with annual capacity of 10.5 million tonnes. The plans of the Russian producers, with competitive production costs, could have heavily impacted profit margins for Mosaic. However, as they say, the best laid plans.
In late 2014, the major Russian potash producer, Uralkali, part-owned by an ally of Vladimir Putin, had an accident at one of its major mines that forced its closure. While the company attempted to downplay the significance of the accident, the market was skeptical. This event cast some doubt on the concern over the severity of the first “blemish” on Mosaic.
Russian competition was not the only blemish for Mosaic
But there was still another pesky issue facing Mosiac that had nothing to do with market competition. The company had managed to come to the attention of both federal and state environmental regulators through the EPA. Anyone familiar with the aggressive nature of the EPA, at both the state and federal levels, can tell you that it can be really difficult to guess where the eventual bottom of that hole might be found, if ever. Problems with the Russian friends of Putin pale in comparison.
However, last week, the company announced it had reached an inclusive settlement with the Department of Justice and the EPA to resolve these issues and allow it to move forward. In some reports, the settlement was described as a $2 billion hazardous waste settlement where other sources proclaimed it to be $800 million. In truth, it can be said that both are correct and neither tells the real story. But, hey, you have to have a headline that grabs attention.
By issuing a press released containing huge numbers, the regulators can claim they have severely punished a serial violator and set an example for the industry. In reality, the company will face about $638 million in punitive penalties and spend about $170 million on improvements to their own facilities.
At the end of the day, this settlement agreement removes a huge cloud of uncertainty over the business and the final blemish that appears to have been causing concern on the part of investors. The price action in the shares over the last couple of sessions gives us a pretty good indication that the market views this as favorably as I do. After trading as low as $29.61 on Friday morning, the shares have surged over 8% to $32.01 as I type. While this is an impressive move in a very short time, the stock is still trading 40.5% below its 52-week high of $53.83 established on Feb. 25.
How is the business currently valued?
As illustrated by the chart below, over the last 12 months, Mosaic has reported earnings of $3.18/share. Based on Friday’s closing price of $30.99/share, the price-to-earnings multiple for the business based on trailing 12 months (TTM) earnings is an inexpensive 9.74 compared to its median P/E of 18.59.
This provides us with a solid indication that the company is currently undervalued compared to its historic norm in terms of price to earnings. Having made that statement, I would not even considering a new investment in this business at a current P/E multiple of 18.59 times trailing 12 months earnings.
While the Standard & Poor's 500 is currently trading at a P/E ratio of about 19.9, I tend to shy away from individual stocks trading at that sort of lofty valuation since I rarely believe they are justified by realistic expectations for future growth. However, critical businesses with P/Es under 10 really do attract a second look from me.
Is there a margin of safety in this business?
In any business to which I allocate my capital, I like to have some degree of extra assurance that the business will be able to survive some adverse event, just like the kind that Mosaic just settled. In this case, the company carries a balance of cash and short-term investments that is $$327 million greater than all of its short-term liabilities combined.
In addition, one of the ways to evaluate the efficiency of management in many businesses is to look at the number of times each year they turn their inventory. At the end of June, the company reported inventory levels of $1.612 billion of inventory. Their average monthly sales have been running at about $2.314 billion/month. This produces 17.2 turns per year on the inventory balance and is an exceptional number for a business this size. This number is indicative of how quickly the business can convert inventory to cash. We want a number as high as possible.
What is the current fair value of the business?
When attempting to assign a current “fair value” to a particular stock, I try to avoid using comparisons to broad market averages. The reason for this is that the forward prospects for each business in a large index have far too many variables to make any real comparison of valuation of a single stock to an index almost meaningless.
Instead, I like to look at a company’s future prospects and its current valuation compared to those projections as well as the historic norms for the valuation of the business.
The table below, available from the Fidelity Investments website, reveals that Mosaic is expected to grow its earnings at an annual pace of 10.5% per year for the next three to five years.
There are many ways to assign current value to a stock based on future projections for growth. Most analysts will use a multiple between one and two times the earnings growth rate (PEG) multiplied by earnings for the previous fiscal year, trailing 12 months, projected earnings for the current fiscal year and projected earnings for the coming fiscal year.
Since I like to err on the conservative side of my analysis work (after all, it is my money), I like to use a PEG of one plus the dividend yield to determine current fair value. My reasoning for this approach is pretty simple. I am interested in total return on my capital. This will be determined by two components of the investment: capital gains from a rising share price and dividends paid to me by the business. If I buy a business that is cheaply valued today, it is reasonable to assume that the stock price will rise in direct proportion to any growth in the earnings. Since any dividends collected will be in addition to that, the income can be added to the expected capital gains to determine my projected annual return. Any increases in dividends paid just become gravy.
Mosaic earned $2.65 per share in 2014 which produces a P/E of 11.69 times last year’s earnings.
Using the TTM for the 12-month period ended in June, the company reported earnings per share of $3.18 per share. Based on this number, the company is trading at 9.74 times earnings as of last Friday’s closing price.
If we apply the earnings estimates of $3.19 per share, from the analysts covering the stock, for the current fiscal year that will end in December, we get a P/E ratio of 9.71 times the current year earnings.
With a projected long-term growth rate of 10.5% per year for company, the current valuation just below 10 times earnings appears to be fairly close to fair. However, in the case of Mosaic, the company is paying a 27.5 cents quarterly dividend that produces a 3.55% yield. This would indicate that the return on investment we can expect going forward is not the 10% growth rate of the earnings; but more likely to be in the range of 14% per year. The sum of a share price growing on pace with the increase in earnings PLUS the 3.55% dividend yield.
A 14% annualized return on investment is a pretty attractive result when it is achieved on a very conservative valuation approach.
How is the business valued compared to its historic norm?
Another interesting way to look at a particular business is to compare the current valuation compared to the historic valuation with a metric such as P/E ratio. In the case of Mosaic, we can find this in the chart below.
Interestingly enough, this chart shows the historic median P/E multiple for Mosaic is 18.59 times earnings, only slightly below the current level of the S&P 500. If applied to the stock price to establish current fair value of the business, we get a share price of just under $60 per share.
We can apply the same process to the share price based on historic median price to book value and see that the fair value of the shares based on this metric would also be just below $60 per share and only about 10% above where the stock price was in February.
Final thoughts and actionable conclusions
The conclusion here seems pretty clear. We have a stock in Mosaic that, based on a very conservative assessment, is very fairly valued and should provide new investors with the expectation of 14% annualized returns for several years to come.
With this same business, if it were to return to its historic median valuations based on P/B or P/E, you are looking at a capital gain of over 85%. This stock looks like a strong buy up to $35 per share. If you hesitate long, the opportunity will be gone.
