Three lessons from Alumina

Here's the secret to investing in resources stocks: buy in gloom and sell in the boom. Like all the best ideas, this is simple but not easy. Yet we're happy to say this is exactly what we've done with Alumina.

When we first recommended Alumina back in 2011, it was in trouble. Alcoa World Alumina and Chemicals (AWAC), the world's largest bauxite and alumina producer, in which Alumina holds a 40% stake, had seen operating margins halve within six months and fall by two-thirds since peaking. It was barely profitable.

In fact, the entire industry was suffering as structural change ravaged the aluminium market and kept alumina prices low.

Too low, we thought. We argued that structural change in the aluminium market would ultimately lead to higher alumina prices and a restoration of operating margins at AWAC.

Before that happened, however, there was a lot more pain. AWAC had to close plants and cut costs savagely, and the industry had to lower capacity. No-one wanted to invest in Alumina while commodity prices were ratcheting lower and the share price promptly halved.

Lesson 1: Cheap can get cheaper

Which brings us to the first lesson from our Alumina tale: a cheap stock can get cheaper.

In fact, if you are buying a business cheaply it means it is unpopular for some reason, most likely because something is going wrong. You don't get cheap prices next to neat, popular narratives.

When things go wrong it takes time to make them right. It's unlikely you'll pick the exact bottom, so you should expect prices to continue falling.

Investors all want to buy a stock and watch it rise from the moment they make the purchase and we imagine the hardest part of investing is pulling the buy trigger. In fact, the hardest thing to do is to hold when prices are falling and everyone is negative. We need to train ourselves to be comfortable holding stocks as they fall as long as our investment case holds.

Panicking and selling because the price has fallen is the worst sin because you are allowing others to dictate your own actions. Don't fall for it (although we all do it).

It's too easy to fixate on the falling price of a stock you've just bought, and that obsession can create psychological hurdles. You might overcome them by flipping the narrative: only a lazy investor buys at the bottom. An alert investor would buy a stock as it becomes cheap and may have to watch it become cheaper still. Rather than being wrong, you are being alert. 

Lesson two: Buy in bits

Which neatly brings us to lesson number two: if you are going to buy beaten down stocks, buy in tranches.

We first recommended Alumina at $1.44 in 2011. If you had bought then and only then, you would have doubled your money. That sounds pretty good but, over seven years, it amounts to a return of only 10% a year – respectable, but not outstanding particularly given the risks involved.

Yet we reiterated our buy recommendation at 95c (here) and, most forcefully, at 65c, where we noted that Alumina was trading at half its replacement cost. That's pretty darn cheap.

The investor who dripped money into the position would have been able to lower their entry price and raise their returns. The average of all the prices at which we recommended buying was $1.04 against an initial price of $1.44 and, by staggering purchases, an acceptable return could be turned into an excellent one.

We often acknowledge patience in holding stocks but patience when accumulating them can be just as beneficial.

Lesson three: Be open

Value investors are seldom found in resources stocks and it's not because value is seldom found. Most value investors find resources anathema to the 'value thing'.

I've lost count of the number of times I've heard intelligent value managers say they outright just don't buy resources stocks because they produce commodities and lack pricing power.

So here is lesson number three. Force yourself to look where others aren't looking.

The resources sector is largely filled with optimistic yahoos who can't value stocks and have little interest in doing so. It is a sector bombarded with hype, spivs and charlatans. Which is exactly what makes it so attractive for the conservative and sensible.

I would much rather compete with a salivating, unthinking fool than a rational investor and resources uniquely provides the opportunity for that contest.

With its combination of wild cyclicality and wilder swings in sentiment, no other sector provides the opportunity for mispricing as much as this one.

Miners as value

The usual momentum buyers forsake resources when they are falling and value guys seldom step in when they are cheap. In practice, this means that everyone wants to buy BHP at $50 and no-one wanted to touch it at $14. We see it all the time and we will see it again.

If you are an investor who swears off resources, avoidance is probably the right answer 95% of the time – but perhaps you ought to consider the other 5% of circumstances.

Every business contains variables beyond its control: retailers are at the mercy of fads; telcos bend to technology; real estate depends on interest rates and health businesses rely on regulators. Every industry has known unknowns and in mining that happens to be price.

Don't buy mining stocks if they are expensive, if they make lousy returns on capital or if they allocate capital poorly. But not considering them because they are price-takers is too simplistic.

Miners are unlikely to be disrupted by technology or by geeks in a garage. Volume and cost are usually well flagged and, over time, returns on capital are surprisingly stable. Like every other industry, mining has its pros and cons. Too many of us of focus on the obvious and ignore the nuanced. Lessons aren't only found in the ruins of our mistakes; we can also learn from the ideas that work.

Intelligent Investor is loading up the van and going on tour in April and May, with events on the QLD mid-north coast and in Brisbane, Perth, Adelaide, Melbourne, Sydney and Canberra. If you'd like to hear us talk about building a portfolio to weather any storm, book your spot here.

Note: The Intelligent Investor Growth and Equity Income portfolios own shares in BHP. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.