Why Wall St. Digs Raw Materials

Cleveland-Cliffs Inc. has not discovered a cure for cancer, nor has it patented a new Internet search technology.

The company does something that Wall Street finds much more exciting these days: It mines iron ore pellets in the wilds of Michigan, Minnesota and Canada.

Cleveland-Cliffs shares have rocketed from $25 in July to a record high of $86.19 as of Friday, a 245% gain. If you were chasing after Google Inc. late last summer, it would seem that you were missing a far bigger opportunity.

There’s a lot of that kind of second-guessing going around, and it was amplified last week, when many commodity-related stocks including Cleveland-Cliffs jumped to fresh record highs.

Wall Street has been developing a better appreciation for classic smokestack businesses for the last two years, as the U.S. economy has revived and as China and other emerging economies have stoked demand for raw materials and all sorts of industrial goods.

Lately, however, appreciation for the stocks has given way to near-panic buying. Some investors who paid no attention to these issues for a decade or longer -- if ever -- now seem willing to pay any price to get into them.

Buying into panics is a dangerous game. It was five years ago this week that the dot-com stock craze reached its zenith, pushing the Nasdaq composite index to a record 5,048.62. At last week’s closing level of 2,070.61, the technology-dominated Nasdaq still is down 59% from its pinnacle.

But the final peak in any market cycle is only evident well after the fact. Some people who are buying mining, energy, steel and other smokestack stocks today believe that many of the companies are in the early phase of a long-term growth cycle -- perhaps where the tech sector was at the start of 1997, with two solid years under its belt and three more to go.

“Mining is the tech sector of the new century,” declares Christopher Ecclestone, an analyst at Hallgarten & Co., a small investment research firm in New York.

That kind of talk can get an analyst (and his clients) in trouble, and it’s a real stretch to compare an innovation-driven industry like tech with another that merely extracts valuable elements out of the dirt.

Nonetheless, Ecclestone does make a good case that there are strong fundamentals underpinning mining companies such as Freeport-McMoRan Copper & Gold Inc., Noranda Inc. and Phelps Dodge Corp.

Mining is a business that has been largely consolidating for two decades, as prices for raw materials generally moved lower through the 1980s and 1990s, Ecclestone says. There was no incentive to add production capacity in those decades.

Now, as the global economy revs up -- powered by heady growth not just in China but also in India, the Pacific Rim and Eastern Europe -- demand for commodities including copper, zinc and nickel is soaring, and prices naturally have jumped.

The U.S. dollar’s sharp decline since 2002 has aided and abetted the global hunger for commodities, because raw materials typically are priced in dollars. That means they are relatively less expensive for countries whose currencies have strengthened versus the buck.

And even though many commodity prices are back to their levels of the early 1980s -- generating bad memories for fans who remember the peak of the last commodity cycle, and the crash that followed -- it’s important to note that, adjusted for inflation, prices of oil, metals and other raw materials today are far below their 1980s heights.

Expectations of much more to come have helped to fuel the performance of the few mutual funds that focus on commodities. The Pimco Commodity RealReturn fund and the Oppenheimer Real Asset fund, for example, both invest in commodity-linked derivative securities. Both funds have been red-hot this year.

Of course, if mining companies were to quickly bring on a lot of new production capacity, their boom could fizzle in a hurry.

If they don’t add major capacity, however, and global demand remains strong, there’s great potential for miners to reap healthy earnings for years to come, Ecclestone and other mining bulls say.

“Users did not pay enough to miners over 30 years to adequately reward the risk that miners take,” Ecclestone said. Now “miners can finally write their own checks. No one is rushing to break ranks and add vast new production, even if they could.”

He’s also betting that a significant chunk of miners’ earnings will be returned directly to shareholders via dividends -- at a time when dividend income again is fashionable on Wall Street.

None of this is news to big investors. They’ve been hearing it for two years. But that doesn’t make it any less true. And in an environment in which many investors are struggling to find stocks that might produce something better than low-single-digit annual returns for the rest of this decade, the smokestack story continues to resonate.

Yet at some point, soaring stock prices will factor in virtually all the good news that may be ahead, and then some.

Are we there yet with commodity and other industrial stocks?

Bob Howard, who writes the Positive Patterns market newsletter from Springfield, Mo., has been bullish on energy stocks for some time. But he said he had become wary of the sector as more investors had jumped in this year, driving most big-name oil and gas shares to record highs.

The so-called XOI index of 13 major oil stocks hit a record on Friday and is up 23% just since Jan. 1 as crude oil prices have leapt back above $50 a barrel.

“Now all of a sudden the oil doubters are believers,” Howard told his subscribers last week. “Now we see people on the tube saying oil will go to $100 a barrel, and everyone nods their head. ... [It] sounds like all the energy bears are finally throwing in the towel. What does that tell us?”

He’s advising clients to consider taking some profits in stocks like Exxon Mobil Corp.

At the same time, Howard sees opportunities in commodities such as timber and gold.

“I do believe the bull market for these commodities is just beginning,” he said, pointing to names such as timber company Rayonier Inc. and gold miner Placer Dome Inc.

Robert Shearer, manager of the Merrill Lynch Equity Dividend mutual fund, is wary of most steel stocks, he said, because that is one commodity business in which substantial new capacity is on the horizon, particularly in China.

But he said he continued to emphasize other basic-materials stocks in his portfolio, including miners and energy companies. Wall Street analysts, Shearer said, still are playing a game of catch-up in trying to accurately estimate how much money these companies can make if the global economy continues to expand.

Case in point: A year ago, analysts thought Cleveland-Cliffs might earn $2.50 a share this year. Now they’re projecting $9.15 a share on average.

The risks to the commodity story are many: Rising interest rates could damp world growth; the dollar could strengthen; raw-materials production capacity could expand at a much faster rate than investors are expecting; or the stocks could just get too far ahead of the companies’ fundamentals.

The good news is that there still are many investors who automatically shun these stocks, Ecclestone said. “It’s just anathema to them that anything so old and crusty could be sexy,” he said.

But that’s also a big crowd of potential converts if the commodity story keeps improving.

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Tom Petruno can be reached at tom.petruno@latimes.com.