Interactive Investor

Trading Strategies: a FTSE 100 stock with wide margin of safety

There’s an abundance of undervalued, high-quality UK companies with upbeat long-term prospects, offering a clear alternative to overpaying for American stocks. Columnist Robert Stephens analyses one with a favourable risk/reward ratio.

29th February 2024 10:33

Robert Stephens from interactive investor

A soaring S&P 500 index that recently reached an all-time high, masks a highly unpredictable future for the world economy. Certainly, inflation is set to continue its decline so that it eventually meets central bank targets across developed economies. This is extremely likely to ultimately prompt interest rate cuts in the US, UK and Eurozone that have a positive impact on GDP growth and the operating environments of a wide range of companies.

However, many investors seem to believe that all of the above will take place over a relatively short time frame. Moreover, they appear to be expecting the process of interest rate cuts to be smooth and void of any major complications. This is despite high inflation having continually proved to be far more stubborn than anticipated and the rate of price rises still being substantially above central bank targets. And while interest rate cuts are undoubtedly on the horizon, their timing and scale seem to continually be subject to pushback by central banks as economic data, particularly in the US, remains surprisingly robust.

As a result of this disconnect between investor expectations and economic reality, there is a danger that many stocks, especially those listed in the US, are becoming significantly overvalued. Given that there is elevated political risk, both in the US and UK, from elections in the coming months, investors must ensure that they do not purchase, or indeed hold, stocks that lack a margin of safety. Otherwise, they may find that any disappointment regarding the timing and scale of interest rate cuts, as well as upcoming economic policy changes, leads to a vast decline in the value of their holdings over a short period.

A wide margin of safety

Of course, the UK stock market is in a very different situation to its US peer. The FTSE 350’s lacklustre performance over recent years means that a large proportion of its incumbents have market valuations which are significantly below their intrinsic values. This apparent unpopularity is extremely helpful for any investor seeking to purchase shares, since they are able to buy high-quality companies at attractive prices. The wide margins of safety on offer not only provide a degree of protection should disappointment regarding the timing and scale of interest rate cuts materialise, but also equate to significant capital growth potential over the long run.

Underperforming stocks, though, do not generally ignite investor interest. Even if a company has a solid financial position, significant long-term growth potential and a sound strategy, many investors will be put off by a lagging share price. They would seemingly rather wait for its price to rise substantially before buying it. This is an idiosyncrasy of the stock market, with practically every other industry in the world experiencing higher demand for goods and services when prices are low. But with the majority of profits generated by FTSE 350 firms being from abroad, and in some cases its incumbents having material exposure to the fast-growing US economy, the relatively low market valuations of UK-listed shares are unlikely to persist ad infinitum.

Indeed, with the FTSE 350 index offering an abundance of undervalued, high-quality companies with upbeat long-term prospects, there is a clear alternative to overpaying for S&P 500-listed shares. Purchasing UK-listed shares may mean going against the investment herd and missing out on short-term gains as the prospect of lower inflation and interest rate cuts drives US stock market valuations even higher. But it also means avoiding overvalued shares that could fall heavily should the current Goldilocks outlook prove to be an unattainable goal due to economic and political realities.

An undervalued FTSE 100 mining stock

Company

Price

Market cap (m)

One-month performance (%)

Shares in 2023 (%)

Shares in 2022 (%)

Current dividend yield (%)

Forward dividend yield (%)

Forward PE

Anglo American 

1,710p

£22,873

-9.4

-39.1

7.3

4.5

4.1

9.9

Source: SharePad on 28 February 2024.

Anglo American (LSE:AAL)’s share price currently offers a wide margin of safety. The FTSE 100-listed mining company trades on a price/earnings (PE) ratio of less than 10 after experiencing a share price fall of over 9% in the past month. Its financial performance has suffered of late from cyclical lows in its diamonds and platinum group metals segments, with the firm recording a 51% decline in earnings per share in the 2023 financial year.

However, the company’s long-term prospects remain upbeat. Its significant exposure to future-facing commodities such as copper and iron ore means it is well placed to capitalise on rising demand as the world seeks to achieve net zero.

Copper, for example, is used extensively in electric vehicles and renewable energy infrastructure, with it being in short supply as a result of a lack of major exploration discoveries over recent decades. The metal accounted for roughly a third of the firm’s overall profits in the latest financial year, which was up from 15% in the 2022 financial year, with its Quellaveco mine in Peru fully ramping up and producing 319,000 tonnes of copper in 2023.

Iron ore, meanwhile, is set to experience growing demand due to it being used in wind turbines and other renewable energy infrastructure. It accounted for around 40% of the company’s profits last year, with higher prices and rising sales volumes contributing to a 16% year-on-year increase in segmental profits. And while the company’s exposure to crop nutrients represents a long-term investment that is not expected to begin production until 2027, it nevertheless offers growth potential as an expanding world population requires a larger amount of food.

A sound business with growth potential

In the short term, Anglo American’s solid financial position means it is well placed to overcome continued sector-related uncertainty. For instance, its net gearing ratio stands at a relatively modest 34%, while net interest payments were covered seven times by operating profits in 2023 despite a weaker financial performance. The company also expects to reduce annual costs by $1 billion over the next three financial years, while cutting out unprofitable volumes as it seeks to focus on financial returns rather than scale.

While the timing and extent of interest rate cuts are highly uncertain, a more accommodative monetary policy is set to ultimately catalyse the mining industry. Greater levels of economic activity have historically prompted higher demand for a wide range of commodities. With their supply being limited in many cases, prices could rise to provide a boost to profitability across the sector. This could reinvigorate investor interest in mining companies that are currently relatively unpopular.

Although mining stocks are notoriously unreliable when it comes to dividend payouts, as evidenced by Anglo American’s 52% decline in shareholder payouts last year, the company still offers a relatively attractive yield in excess of 4%. And with dividends being covered 2.5 times by profits, they could rise substantially given the prospect of improved operating conditions in the coming years.

Clearly, the company’s share price could remain volatile as a result of the world economy’s uncertain outlook. While many investors seem oblivious to the potential for a more challenging economic outlook than that currently assumed, Anglo American’s share price includes a wide margin of safety which factors in further sector-related difficulties. Given its solid financial position, long-term growth potential as the world transitions to net zero and capacity to reduce costs, the stock offers a favourable risk/reward ratio.

Robert Stephens is a freelance contributor and not a direct employee of interactive investor.  

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