Mine the White-Hot Metals

Nickel and zinc hold big potential, and these three stocks can get you in on the action.
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The commodity rally in metals is back. In fact, the metals sector has been on fire for three months.

You've missed the easiest gains, I'm afraid. And the risks are higher than they were in January. But, while it's too late -- and too risky -- to jump into the rally in copper stocks, it's not too late to pick up good gains in nickel producers. And zinc stocks could yield the biggest gains of all.

You can dodge the risk and pick up solid profits for the rest of 2007 -- if you pick the right mining stocks.

Let's look at the recent rally.

Southern Copper

(PCU)

is up 54% from its Jan. 8 low through the market close on April 11.

Freeport-McMoRan Copper & Gold

(FCX) - Get Report

, up 39%.

Companhia Vale do Rio Doce

(RIO) - Get Report

, up 49%.

BHP Billiton

(BHP) - Get Report

, up 37%.

Yes, shares of metals miners over the past three months have been hotter than a smelter on an August day. And, no, I haven't owned much in the sector, with the exception of BHP Billiton and

Anglo American

(AAUK)

, which is up 23% from its Jan. 5 low.

I admit it: Distracted by worries about a potential slowdown in the U.S. economy, the meltdown in markets for mortgages to the least creditworthy borrowers and the ups and downs of oil prices, I missed a huge rally in copper, nickel, aluminum, zinc, tin and lead.

So what's an investor to do?

Too Far, Too Fast?

Start with a top-down view of the financial markets to decide how much of the rally is over. And finish with a bottom-up view of individual metals and mining companies to see what stocks still have the potential to surprise Wall Street.

Top-down first: The easy money in this rally is gone. It doesn't hang around long these days.

In the current market, momentum players may start a rally, but speculative money isn't ever very far behind. The billions managed by hedge funds and the expanded proprietary trading desks of big investment firms pretty much guarantee that any rally will quickly attract a flood of hot money looking for the latest trend. Under these circumstances, rallies quickly run to excess.

The big move in the price of copper, the commodity, and copper stocks in the recent rally is a good example. Yes, there are signs that the Chinese have sold off the copper inventory that temporarily depressed copper prices around the middle of 2006. And yes, Desjardins Securities predicts that global copper demand will grow by 5.1% in 2007, up from growth of 3.6% in 2006. So copper prices should be climbing, and copper stocks should be rallying.

But a gain of 5% in one day on April 10? And a gain of 48% from early February to early April? Too far, too fast. It's not just that benchmark copper prices hit a seven-month high of $7,710 a metric ton on the London Metal Exchange on April 10. It's that hedge funds, according to the

Financial Times

, have started to talk about copper prices breaking the record $8,790 a metric ton set in May 2006. (A metric ton is 205 pounds heavier than the 2,000-pound short ton measurement used in the U.S.)

When the speculative money starts counting its chickens before they've hatched, you know the easy money has long ago been picked up off the floor.

Hot Money on the Run

That doesn't mean that copper and copper-mining stocks can't go higher. A flood of hot money can be followed by another flood of hot money that washes stock prices still higher. But the more that hot money drives up the prices of stocks in a sector, the greater the risk that a change in sentiment will trigger a big outflow of hot money, sending stock prices in the sector plunging.

That's especially a danger for copper and copper-mining stocks now, because we know that even a whiff of bad news from the U.S. housing industry, a big customer for copper, can set the hot money fleeing. And there's no way we've put all the bad news from the housing market behind us.

But a look at the reasons for the big move in copper points investors toward other metals and mining stocks that offer a better combination of risk and reward right now. It's quite simple, really: Demand is growing faster than supply. And demand looks to stay ahead of supply well into 2008 at least.

According to Desjardins Securities, copper supply will run behind copper demand to the tune of a 50,000-metric-ton deficit in 2007 and 55,000 metric tons in 2008.

Where does the market get the copper to make up the deficit? From existing inventories. But as inventories get drawn down, the price of copper goes up. As of the end of March 2007, the three big copper markets in London, New York and Shanghai showed inventories of about 270,000 metric tons. Desjardins projects an average price for copper of $3 a pound in 2007 and 2008. (On April 12, 2007, copper closed at $3.58 on the London Metal Exchange.)

Investors can find the same supply-demand imbalance in nickel, where, again according to Desjardins Securities, the market went into deficit in 2006 and will stay in deficit in 2007 (by 16,000 metric tons) and 2008 (by 20,000 metric tons). That's a huge deficit, considering that Desjardins put nickel inventory at just 5,418 metric tons as of March 30, 2007. (Inventory figures aren't very exact. Higher prices tend to reveal that there's more inventory than expected in unexpected places.)

Desjardins estimates that this supply/demand squeeze will push nickel prices up to an average of $16 a pound in 2007 from an average of $10 a pound in 2006. For 2008, the price will also average $16 a pound, Desjardins projects, while CIBC World Markets sees the price falling to $13 in 2008 from $16 in 2007. Recently Deutsche Bank raised its nickel forecast to $17.59 for 2007 and $15.44 for 2008.

A Safety Net for Nickel

Investors also get superior downside protection in nickel. A good chunk of global nickel production comes out of Chinese smelters that import laterite, the ore used to produce nickel. Chinese imports of laterite have soared, beginning in September 2006 when they reached 700,000 metric tons and were still running above 500,000 metric tons in January and February 2007.

Because the production costs at Chinese smelters using imported ore are extremely high, if nickel prices were to fall, some of this Chinese production would shut down. That puts a floor -- an imperfect one to be sure, since some Chinese producers will continue to produce even if they're losing money -- under nickel prices.

Zinc prices haven't climbed as fast as those for copper or nickel, because zinc consumers have been working through inventory in the second half of 2006 and into 2007. That has made supply seem higher than it is and had the effect of masking the huge supply deficit in zinc of 665,000 metric tons in 2006, according to Desjardins, and a projected 140,000 metric tons in 2007.

Desjardins projects that zinc prices will hit $1.80 a pound on average in 2007, up from $1.40 in 2006. CIBC World Markets projects a more pessimistic $1.68 for 2007, but even that's above the London Metal Exchange cash price for zinc of $1.60 a pound on April 12. So zinc, unlike copper and nickel, is trading below the average price projected by both investment houses for 2007. That gives the metal and the shares of zinc miners an edge looking forward over other metals and mining stocks.

From the bottom up, company fundamentals point me toward shares of three companies in the nickel and zinc groups.

A Timely Buy

First, iron and nickel producer Companhia Vale do Rio Doce. The Brazilian company bought Canadian nickel producer Inco just in time to catch higher nickel prices in 2007. (It doesn't hurt that iron ore prices, about 20% of revenue in 2006, are headed up in 2007. At the end of March, Deutsche Bank raised its iron ore forecast by 16% for 2008. The company's iron ore mines are the lowest-cost producers in the world.) Production of both iron and nickel is growing at the company with output of iron ore and nickel set to increase by 14% each in 2007.

Need I say that in a bull market for commodity prices, you'd like to own shares of a company that's increasing production? The company's biggest new mines, in Brazil and New Caledonia, are projected to begin production in 2008 and 2009, respectively.

Focus on Mining

Second, consider zinc smelter and miner

Zinifex

. The Australian company is in the process of making the transition from being a zinc smelter to being a pure zinc-mining company. Zinifex signed a December 2006 deal to combine its smelting operations with those of

Umicore

. A late 2007 IPO of the spun-off smelting business is in the works. And a deal to acquire Canadian exploration company

Wolfden Resources

will add two high-yield Canadian ore deposits to Zinifex's reserves.

It also will provide reassurance to investors worried about the gradual depletion of Zinifex's production base and particularly the 2016 projected depletion of the company's Century mine in Australia. The company also expects its Dugald River mine in Australia to be in production by 2011. (I'd expect the stock's high dividend yield to come down in the future as the company draws more deeply on cash flow to expand production.)

Growth and Cash

Third, look at zinc (and copper) producer

HudBay Minerals

. The Canadian company produces about twice as much zinc as copper -- as well as gold and silver. (The company is the third-largest producer of zinc and copper in Canada.)

The combination will drive earnings in 2007 and 2008 above the already high earnings levels of 2006, according to the consensus of Wall Street analysts. Projected 2007 earnings will climb 28% from 2006 levels. For the first quarter of 2007, due to be reported on May 10, Wall Street is looking for better than 75% growth in earnings per share from the first quarter of 2006. The company's current reserves are enough to sustain production for 12 years at current rates. And HudBay Minerals has plenty of cash -- $254 million -- to expand its exploration program.

At the time of publication, Jim Jubak owned or controlled shares of the following equities mentioned in this column: Anglo American, BHP Billiton and Zinifex. He did not own short positions in any stock mentioned in this column.

Jim Jubak is senior markets editor for MSN Money. He is a former senior financial editor at Worth magazine and editor of Venture magazine. Jubak was a Bagehot Business Journalism Fellow at Columbia University and has written two books: "The Worth Guide to Electronic Investing" and "In the Image of the Brain: Breaking the Barrier Between the Human Mind and Intelligent Machines." As an investor, he says he believes the conventional wisdom is always wrong -- but that he will nonetheless go with the herd if he believes there's a profit to be made. He lives in New York. While Jubak cannot provide personalized investment advice or recommendations, he appreciates your feedback;

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