The sad fact is, many people—and that includes investors—are followers, not independent thinkers. Most people move in groups. Consequently, they tend to allow subjective emotions to overpower their rational decision-making.
Last week’s high-profile victim of mistaken “groupthink” was Freeport-McMoRan Copper & Gold (NYSE: FCX). This inherently strong stock is being unfairly punished by the market—and therein lies a lesson for investors.
Charles Mackay, in his 19th century classic economic book, Memoirs of Extraordinary Popular Delusions and the Madness of Crowds, aptly describes the unfortunate tendency of investors to behave like lemmings. His account of “tulip mania” in 17th century Holland still makes for riveting and instructive reading.
Dutch tulip mania was a meteoric rise in the price of tulip bulbs in the Netherlands in the 1630s, followed by a precipitous crash. Tulip mania is a universal metaphor for the madness of crowds that fosters boom-bust cycles, whether it’s the 1929 stock market collapse or, in recent memory, the housing bubble that burst and heralded the Great Recession of 2008-2009.
In the long run, a stock’s profit or loss depends on whether the underlying company becomes more valuable, or less. But near term, it’s investors’ perceptions that set prices. And that means emotions often have as much weight as facts.
Nothing stirs the blood like market volatility, particularly at a time of uncertainty like this. After nearly four years of mostly rising stock prices, the investing public doesn’t want to be wholly out of the market. That’s especially true of large institutions that increasingly dominate daily trading.
On the other hand, no one wants to be caught in another 2008-style crash. Nor does anyone want to be left holding the proverbial bag when an individual stock crashes. Keep in mind, money managers are evaluated on where they stand at the December 31 close, with bonuses and jobs hanging in the balance.
Put in this context, it’s not hard to see why many investors follow instinct to sell first and ask questions later, if at all. Falling stocks aren’t viewed as potential sources of value, but rather as death traps. And the faster and farther the drop, the greater is the perceived danger.
Which brings us to Freeport. The stock has already endured a volatile year, largely because of shifting investor sentiment on the price of its primary product—copper. On Wednesday, the stock immediately dropped nearly 20 percent after announcing two acquisitions: Plains Exploration (NYSE: PXP) for $6.9 billion and former unit McMoRan Exploration (NYSE: MMR) for $2.1 billion.
Following the combined $9 billion in purchases, energy production will contribute roughly a quarter of Freeport’s cash flow, with copper accounting for most of the rest along with gold and molybdenum production. The company plans to spend approximately $2.5 billion to develop oil and gas in 2013, out of a total capital budget of $7.1 billion.
One of Many
Freeport’s deal is one of several oil and gas purchases by the world’s major mining companies in recent years. Including these two, there have been 19 such acquisitions in 2012 with a combined value of $19.6 billion, according to data compiled by Bloomberg. That follows 13 deals for $20.2 billion in 2011, $7.3 billion in 2010 and $260 million in 2009.
Miners must go ever-further, ever-deeper and ever-more dangerously to secure supplies of vital resources. That takes money, which is best achieved by gaining scale by the most available means.
Freeport’s deal is small potatoes by global mining industry standards. London-based Glencore (London: GLEN, OTC: GLNCY), for example, is currently in the final stages of a $30 billion plus takeover of Xstrata Plc (London: XTA, OTC: XSRAY). At the same time, it’s acquiring Canada’s largest grain handler Viterra Inc (TSX: VT, OTC: VTRAF) in a separate USD6 billion plus deal.
Although the attempt has been shelved for now, a proposed merger of BHP Billiton (ASX: BHP, NYSE: BHP) and Rio Tinto Plc (ASX: RIO, NYSE: RIO) in the last decade would have created a $300 billion company. And rumors of new talks between these two Australian giants periodically resurface, as mining companies increasingly seek scale.
Adding oil and gas production obviously doesn’t increase Freeport’s scale in copper; the company has implemented plans to double output of the red metal the next few years to meet rising demand from China.
However, the acquisitions will provide a new source of cash that’s historically been more reliable than copper sales. Assets include valuable offshore Gulf of Mexico reserves as well as onshore production in the Eagle Ford Shale. And Freeport knows the assets and the players it’s combining with, having spun them out 18 years ago.
The post-deal Freeport will therefore have greater scale and ability to follow through with its development plans, even if the global economy should weaken in 2013. The company will also reduce its dependence on politically volatile areas, such as Indonesia and Africa, and bring its operations in the US to nearly half of cash flow. Management has pledged to maintain the company’s generous dividend policy as well.
Anatomy of a Drop
So why did the stock drop so sharply last week? The culprit was selling momentum—i.e., the madness of the crowd.
Rumors of the deal began to hit the headlines on Tuesday, with the Financial Times reporting a prospective transaction worth $10 billion. That was followed by the actual announcement the next day, along with a conference call and a question-and-answer session with top management.
Reaction was immediate and harsh. Private capital firm Blackrock’s lead analyst questioned the deal’s rationale and accused the company of “breaking investors’ trust.” Charging “investors obviously have the freedom to diversify their own portfolios” and “don’t need management teams to do it for them,” he went on to demand a vote on the deal by Freeport shareholders. Other analysts promptly echoed those harsh comments.
The result: Six research houses downgraded the stock. S&P cut Freeport’s outlook to “negative” on “the leveraged nature of the transactions,” and Fitch put the company on negative credit watch.
Piling on is the essence of momentum investing. There were also several upgrades after the conference call, some quite stridently bullish on Freeport. But it’s hard not to get the sense that every new downgrade upped the pressure on the remaining analysts to issue their own opinion with a skeptical bias.
Ironically, most of the damage to Freeport shares was done at the open on December 5, immediately following the news. Since then, the stock has pretty much fluctuated around $31 to $32 a share on very high volume.
Following the myriad negative opinions that came out afterwards wouldn’t have done anyone much good. In fact, several of the downgrades were apparently based only on the concerns that “investors” didn’t like the deal, rather than whether or not it made sense to the writer on the business merits.
The press didn’t help matters. Business journalists often aren’t financial experts; typically they’re generalists who glibly encapsulate the common consensus. If a certain company is getting a lot of bad press for a supposed misstep, sending its stock into a free fall, it often signals a great buying opportunity.
To be sure, whenever a company launches a major deal, it’s taking chances. Freeport has limited uncertainty by pre-arranging $9.5 billion in bridge financing and doing much of the purchase in stock. The transaction also needs only the approval of clearly motivated McMoRan shareholders and mostly avoids the regulatory gauntlet, which should make for a quick close.
As I wrote above, management is familiar with the assets and the players, by virtue of a continuing relationship since the spinoff 18 years ago. Even S&P acknowledged the conservative financial policies of Freeport management, when it put the acquired companies on credit watch for upgrades.
Natural resources are an ever-volatile business with no guarantees of success. Anyone who invests in a company like Freeport has to be ready for volatility.
For the past several years, Freeport has clearly been in a growth mode, sometimes with acquisitions such as Phelps Dodge in the last decade and lately with the construction of five super copper mines around the globe. This deal may help catapult Freeport to the ranks of super resource companies, which is management’s clear ambition. Or it may impede those goals.
We may not learn the answer to that for some years. What we do know, however, is the detractors have already condemned Freeport to failure. And that’s despite the company’s formidable track record in recent years of closing successful deals to expand its business.
Could that be because Blackrock and others were counting on a big return from Freeport by December 31 for a boost in an otherwise tough year? Perhaps. But whatever the case, long-term investors should recognize their interest doesn’t lie in where the world stands on January 1, but whether or not Freeport has what it takes to build wealth over the long haul.
Sharp drops in any individual stock are alarming. But it’s clear to us that Freeport has just done a deal that could genuinely aid its long-term development efforts, and with relatively little risk to shareholders. The stock deserves at least some benefit of the doubt.
In fact, McMoRan would have to pay a breakup fee were it to walk away. And don’t forget this deal is being done after a rough year for energy producers. Despite the premium to pre-announcement prices, there’s a considerable case to be made that management is actually buying low.
My bet is Freeport succeeds this time, just as management has consistently prevailed since I wrote up the stock for the first time back in 1986. Back then, it traded as plain old Freeport McMoRan, a diversified mining and energy company working tirelessly and successfully to unlock value for shareholders.
Don’t get me wrong: I’m not betting the farm on this or any other single stock. But as one of a portfolio of value stocks standing tall in a market obsessed with momentum, I’m looking forward to many happy returns in the years ahead—as emotions shift and company worth ultimately shines through.
In a market like this, there are quite a few opportunities to observe crowd behavior. The key to seeing through folly is to focus on companies’ value and form your own opinions based on your own interests. For 9 more of my favorite commodity plays, see my free report, The 9 Commodities Investments on the Verge of Breaking Out.
This article by Roger Conrad originally appeared on Investing Daily under the title: Freeport’s Free Fall and the Madness of Crowds.