While America waits in post-election, pre-vaccine limbo, I’ve decided to take a few weeks and write about some of the stocks I’ve purchased within the past two years that are sort of on the fringe of my standard analysis. My preference when purchasing stocks is for plain vanilla growth-at-reasonable-price ideas or cyclicals with dependable long-term recovery patterns, but every now then stocks come along that are kind of on the edge of my metaphorical “strike zone”. Albemarle (ALB) has turned out to be one of those stocks.
I’ve written about Albemarle once before on Seeking Alpha, back in July of 2018 with my article “Albemarle: Cyclical Value? Or Super-Cyclical Trap?“. In that article I concluded that Albemarle had indeed gone through some type of supercycle and investors should probably wait for a clear bottom before buying:
So, while I’m not sure how rising lithium demand, potential increased production from competition, and market sentiment will affect Albemarle’s future stock price, I do think that once I see what appears to be a solid double bottom, I’ll be a buyer of Albemarle stock. Now it’s just a waiting game to see when the market tells me it’s good time to buy.
I had mostly forgotten about Albemarle after that article because I figured it would take a couple of years for the stock to form a clear bottom, but in February of 2019 a member of Cyclical Investor’s Club asked me to take another look at the stock, and when I did, it looked to me like it was possible the stock may have put a bottom in and so I bought the stock on 2/26/19. Here is what the price chart looked like between my public article publication and my purchase date several months later:
At the time I thought ALB was at least fairly priced and with the Fed loosening interest rate policy in late 2018 there was a good chance this momentum could carry the stock higher. I didn’t write a public follow-up article about the purchase, but I did drop a comment on my old article.
I ended up being totally wrong about short-term prospects for the stock. Lithium markets became much more oversupplied than expected and the bottom I thought had formed from November through January of 2018/9 did not hold, and the stock price tumbled.
In three months’ time, I was down about -25% on the position. Things were not looking good. But I think it’s times like this that separate the above-average investors from the crowd. When I bought ALB I had both a short-term and a medium-to-long-term thesis. The short-term thesis was absolutely, 100% wrong, but you’ll notice in the comment I shared above that I was prepared to hold ALB through a downturn because I thought the longer-term secular-growth trend was still intact. So, on 5/21/19, I doubled down on the stock and bought more. I think it helped that I didn’t have any other EV-related exposure at all, so this, so far, has been my only way to play an EV secular growth trend that is essentially guaranteed to occur over the next decade.
After making my two ALB purchases, and knowing at this point in time it was going to take awhile for lithium supply and demand to even out, I basically tucked these investments away and didn’t pay any attention to them. Our recession eventually would arrive in March of 2020 and at their low point, the investments weren’t looking too good at all.
At the low point in March of 2020, the first investment was down about -40% and the second was down about -20%. I share this because I think it’s important for investors to understand both the power of a medium-term thesis and the difficulty one might face in the short-term on the way to that medium-term time-frame. I couldn’t have predicted (and in fact didn’t predict) where ALB would eventually bottom. But I had very strong confidence that the longer-term secular growth trend for lithium demand was in place. So, I never once considered selling ALB because the price was down. That’s an important factor that investors need to remember because now these investments are doing quite well:
Overall, we’ve had both good absolute performance and good relative performance compared to the S&P 500. A person just needed to be able to hold through the volatility. Next, let’s examine where Albemarle stock stands today.
Three Important Factors
I’ve marked up the above FAST Graph a lot, but bear with me here. The first thing I like to check with any stock is the historical earnings cyclicality. Adjusted operating earnings are represented by the dark green shaded area in the graph above. I annotated the years of negative earnings growth with red circles. In seven out of the last twenty years, ALB has had negative earnings growth. That’s a fairly high frequency in terms of the number of down years, but the earnings growth declines have historically been pretty moderate in terms of their depth. Until the most recent decline of -35% this year (which was a year in which lithium prices were already low when a global recession occurred) the largest earnings growth decline was -28% way back in 2001. Most of these have been single-digit declines with a couple of mid-teens declines, which I describe as moderate.
There are two other things are worth noting about the declines. The first is that while they tend to be moderate, they often last a few years before bouncing back. 2001-2004 didn’t see any growth, 2006-2009 didn’t see much, and 2012-2015 didn’t see much growth either. So we get these periods of 3-4 years (probably cases where supply and demand need to come back into balance) where we don’t see much earnings growth and sometimes have modest declines. The second thing to note, though, is that the overall trend is clearly up. Even though there are periods of stagnation and consolidation, earnings have been in a secular uptrend since 2002. This is really important because given the coming demand from EVs, we basically know with a high probability that this overall trend will continue during the next decade unless there are some significant technological breakthroughs in battery technology that make it so we do don’t require as much lithium.
In the midst of this modestly cyclical secular uptrend we have a price supercycle that occurs in 2016 and 2017. About half of this upcycle can be attributed really good earnings growth during this time period, and about half I think is fair to attribute to market sentiment getting several years ahead of itself because of bullishness caused by expected EV demand. The combination of those factors caused a really big price cycle (which is what I wrote my last ALB article about).
The eventual downcycle of that supercycle caused a drawdown in the stock price of about -65%, which was similar to what it experienced during the Great Recession in 2008/9. It’s likely the March 23rd low was the bottom of that supercycle.
Now we have a general sketch of the history of the earnings and the market sentiment surrounding the stock. The next step is to use that in order develop a strategy for the investment.
What to do now?
Albemarle is unique because, usually, I can easily separate stocks that are cyclical from stocks that are less-cycle and then perform the appropriate analysis on them to pick some reasonably decent buy and sell prices, either by using fundamental analysis or historical price cycle analysis. Albemarle isn’t quite so easy. In a way it’s sort of like a less-cyclical version of Micron (MU) (which I’ve also traded successfully and written about, but for which it’s difficult to analyze because of its combination of secular uptrend and cyclicality).
My view is that we basic know that the general trend is going to be up over the next decade for ALB, but we have no idea how far up. Competition can and will come into the market, and though it will probably take some time for it to happen, we should expect that any truly astronomical rises in lithium prices will be temporary. So, we know the trend is up and ALB will probably do well, but we also know there will be some limit to how well they will do over the next decade. Interestingly, we’ve already had a version of this trend and cycle take place with ALB from 2016-2020. I fully expect a similar price cycle to happen again. But the question is how high could the stock price go? We know that the market will price in this positive future well ahead of time, and in fact it is already happening right now with the rise in price we’ve already seen since the March lows.
The stock already has a blended P/E of 28 with about mid-teens earnings growth expected over the next couple of years. Let’s call that a PEG ratio of approximately 2. With today’s interest rates, a PEG ratio of 2 is probably about fairly valued. I estimate the wider market’s PEG ratio at about 3, so on a relative basis, ALB is probably 50% undervalued still compared most other stocks in the market, especially since we have a pretty good read on EV demand rising over the next decade. Looking at the stock this way doesn’t exactly make one want to run out and take profits.
It is in situations like this that I think we need to be a little bit flexible, and deviate from the normal playbook. Normally, with a moderately cyclical stock I would calculate a 10-year sentiment mean reversion CAGR and a business CAGR, put them together, and estimate my returns, and hence, the value of the stock. But the sentiment mean reversion becomes difficult to calculate after a big price supercycle (and one that was complimented by a one-time COVID recession). And then for the expected business returns, those too become difficult to estimate if we are in a new secular growth period for lithium demand. We could try to estimate these things, but I wouldn’t have a high degree of confidence in the estimates, and they likely would have already triggered a sale in Albemarle a while back, prematurely.
So, what I plan to do is to treat Albemarle more like I would treat a highly cyclical stock in which earnings and sentiment can fluctuate wildly, somewhat unattached from current earnings trends. For cyclicals, I base when to take profits on the stock’s previously cyclically high price. My thinking behind this is that if the market was willing to pay that price at one time in the past for the stock, then if similar conditions arise again, I have reason to believe that the market will be willing to pay that high of a price again. During the last cyclical peak, Albemarle’s price topped out at about $140 per share, and since I have pretty good confidence that with a secular growth trend intact Albemarle will eventually be able to justify a price that high at some point in the next 5-10 years, then I don’t mind holding on until I at least see that price.
If we do see $140 per share, given the way this market is pricing other EV plays with less solid fundamentals, I think there is a good chance that momentum could keep carrying the price above this, so I’m inclined not to sell as soon as the price hits $140. What I plan to do instead is place a 10-15% trailing stop on if we hit $140, and see if I can capture a little more upside. If I get unlucky and the stock tops out just above $140, then I’m more than happy taking profits in the $120s somewhere if the trailing stop is triggered.
One reason I hadn’t followed up on the Albemarle purchase with a full public article until now is that it has a lot of unique things going on that caused me to adjust my standard analysis of the stock. We can say a few broad things about the stock, but we can’t really have much precision. We know prices for lithium are soft, but likely to improve over the medium-term, and that is what is likely to drive the price of the stock long-term, even though they aren’t exclusively a lithium producer. We know unlike many EV plays, ALB has a solid fundamental business that will limit potential long-term losses, while gaining at least some benefit from EV expansion. We know that we don’t have to pick individual EV winners if we pick ALB (this lowers risk significantly). We know 2021 will likely see a reflation trade as vaccines are distributed and COVID fades. And we can have pretty high confidence that March marked a bottom for the stock price and that momentum has definitely turned positive:
Putting this all together, I think ALB is roughly fairly valued today. If I was putting new money today, I would wait for something like a -20% pullback in the price in order to achieve some margin of safety. But for investors holding the stock as I am, wondering whether to sell or not, I would wait until at least $140, and then try to capture as much upside momentum beyond that as one can get by using a trailing stop. ALB is likely to have a significant drawdown at some point over the next few years. I don’t have a way to predict when it will happen or at what price the stock will top out, but it won’t go up forever if history is any guide. It’s perfectly fine to take profits once we get above $140 per share.
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Disclosure: I am/we are long ALB. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.