Fortescue and the art of value investing

'Up ahead they's a thousan' lives we might live, but when it comes it'll on'y be one.' The most profound insight into investing doesn't come from a famous investor, a billionaire or a businessman; it comes from Ma Joad in John Steinbeck's The Grapes of Wrath, as her family departs the dust bowl of Oklahoma, bound for the orange groves of California, during the Great Depression. 

The world is an uncertain place where infinite possibilities end in a single outcome. As investors, our task is not to predict that outcome. We aren't prophets or soothsayers who can claim knowledge of the future with perfect certainty. Investors should think about the world not in terms of certainties but in terms of probabilities.

This was the mindset we took to our recommendation to buy Fortescue Metals last October.

That has turned out to be an excellent investment, rising over 60% in three months. With our investment case now played out, it is time to take profits. 

Yet this review is not intended to be a celebration. It is an examination. Why, with no special insight into iron ore markets, were we able to make such outsized gains against an army of well informed, smart analysts? 

The buy case

We upgraded Fortescue at a time when its share price had tanked, and the business was on the nose. The gap between high-grade and low-grade iron ore had widened and was crushing Fortescue's margins. 

The market had determined that the price gap - which historically sat at about 10% but had blown out to 40% - reflected a permanent change and had marked down Fortescue stock accordingly. The market was pricing an unknowable variable - low-grade iron ore prices - with dead certainty and it was this that piqued our interest.

Known known

There was indeed a sensible case that low-grade iron ore should remain cheap. The Chinese government had decreed steel producers ought to pollute less and, in response, steel producers swapped low-grade iron ore inputs for high grade. That's the easiest way to ease pollution while maintaining output. 

Everyone knew this and it became the dominant narrative. Yet there was another narrative too.

Steel prices were sky high, earning producers the fattest margins in decades. It was possible, we argued, that steel makers were using high-grade ore because they were incentivised to produce as much steel as possible.

If steel margins ever fell, it was possible that producers would revert back to using cheaper low-grade iron ore and the price gap would narrow.

That is exactly what has happened. Steel margins have fallen from their peaks and producers have switched back to using low-grade iron ore. Stockpiles have fallen and the price gap has narrowed. Fortescue now expects to receive a 25-30% discount, up from 40% a few months ago. All this while iron ore prices are rising.

To be clear, we didn't know this would happen. We claimed no special insight into iron ore markets. We simply saw that another future was possible, and that it wasn't priced into the stock.

Many ways to win

It's easy to forget that miners are complex businesses. Fortescue takes millions of tonnes of dirt, blends it, moves it across vast distances and puts it on huge ships. 

That activity generates lots of opportunities to change grade, cost and output. And it involves ownership of lots of useful assets. Even if prices don't change, Fortescue's operations might.

That too has transpired, with Fortescue planning to raise margins by producing a higher-grade blended product. Again, we didn't know this would happen. The optionality, and how it was priced, is what mattered, not the outcome itself.

Know that you don't know

Investing sits at the intersection between arrogance and humility. It takes great confidence - arrogance even - to proclaim your view right and the markets wrong. Yet we must retain our humility in front of a market that regularly makes fools of all of us. 

We profited here not because we are smarter than the market but because we were aware of our ignorance. 

We knew we had incomplete knowledge of iron ore markets and that recognition allowed us to take other outcomes into account. The market, in this case, was more sure of its view when it's knowledge of iron ore markets was equally incomplete.

It was knowing that we did not know that served as our edge.

We've had some luck as well. A mining disaster in Brazil has forced Vale to close some production. BHP and Rio have risen much less than Fortescue, though, which suggests the market is repricing Fortescue to reflect a narrowing price gap between high- and low-grade ore.

Our investment case has worked out and, with the share price up over 60% in quick order, it's time to take profits. 

As we do, it's important to heed the lessons learned here: think in probabilities, acknowledge ignorance and recognise that endless possibilities will always lead to a single outcome.

Our Model Growth Portfolio is selling its entire holding of 9,841 shares in Fortescue at $6.13 per share, for total consideration of $60,325.33 and we recommend that you do the same. SELL.

Disclosure: The author owns shares in Fortescue Metals Group, but plans to sell when members have had an opportunity to do so.