Vale Valuation

Valuation of the Week #3: Valuing a Commodity Company in risky country

In a post in November 2014, titled "Go where it is darkest", I suggested that investors look at companies that were engulfed with multiple risks. In particular, I looked at two companies, Vale and Lukoil, where the storm clouds of commodity, currency and country risk had all gathered to cause stock prices to drop. In that post, I mentioned that Vale, in particular, looked cheap to me at its then prevailing stock price of $8.53, and my estimated value per share of $19.40.

In April 2015, I revisited the valuation and the darkness had only worsened, as Brazilian country risk surged, iron ore prices continued their fall and Vale's stock price dropped to $6.19. In my post, titled "In Search of Investment Serenity", I took another look at Vale's value and accepting the realities on the ground, the value per share that I arrived at was $10.71, much lower than my November 2014 estimate, but still higher than the stock price. Viewing it as a test of my investment faith, I argued that consistency with that faith required me to stay invested in Vale.

It is now September 2015, and the darkness is now almost pitch black. Iron ore prices have continued their drop, and China's market implosion and economic slowdown have further exercerbated the problem. Brazil's political problems have become worse and the Brazilian Reai hit a decade-long low this morning. Vale's stock price this morning was $5.05, and much as I want to avoid dealing with my money-losing stocks, it is time for me to revalue the company. In particular, I have to bring in the higher country risk into my cost of capital and the revelation that operating income is now down almost 60%, relative to the last fiscal year, which in turn was down almost 50% from the prior year. The valuation is accessible here, and you can see that my value took another hit and the value is down to $4.29, about 15% below the stock price.

Obviously, I would never have bought Vale in November 2014, if I had foreseen the collapse in iron ore prices and the Brazilian political fiascos, but if I had been able to foresee one or both of these macro shifts, I would have been able to make money off them in much simpler ways that working with Vale. Having bought it and paid a price for my misvaluations, it is worth pondering why my valuations were off by as much as they were in November 2014 and April 2015 and I can point at three vulnerabilities:

The perils of normalization: One of the points that I make repeatedly, when valuing individual companies, it to keep your macro views (about the overall level of stock prices, interest rates & exchange rates) divorced from your micro views. I violated that principle in my November 2014, when I left earnings at the trailing 12 month value, which reflected higher iron ore prices over the previous year. It would obviously have been even worse, if I had used the average earnings over the last five years or even ten years. Normalization not only brings a commodity price view into your valuation but is also very much in the eye of the beholder; an average over the last 5 years would have been very different from an average over the last 25 years.
The stickiness of political risk: Of all the risks in valuation, the one that I find most troublesome is political risk. Since it is centered around politicians, with survival instincts front and center, the rational solution is not always the chosen one, the risk feeds on itself and can fester for long periods. The biggest reason for the drop in my value from April 2015 to September 2015 is a surge in Brazil's default spread (and equity risk premium).
The Doubling Down Effect of Debt: Vale is loaded down with debt, a growth steroid in good times but a dangerous accelerant of problems in the bad times. As Vale's earnings and market capitalization have dropped, its debt load has remained stubbornly high, making the effects on equity much more negative.

I am selling my Vale shares, but doing so with no regrets. It is not the first mistake I have made in investing, nor will it be the last one. I am glad that I followed the principles of spreading your bets and not investing money that you cannot afford to lose. You live and learn from your mistakes, and I aim to. If you get a chance and want to give the Vale valuation a shot, please do so and enter your numbers in the shared Google spreadsheet below.

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