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Investment Thesis
SQM (NYSE:SQM) makes about 80% of its gross profits from lithium and derivatives. Any other discussion right now is a distraction.
At the core of the investment thesis are the bearish argument and the admission that lithium prices have fallen significantly in the past several weeks.
But at the same time, it’s crucially important to understand the key drivers of SQM’s medium-term prospects.
Simply put, I’m highly bullish on SQM. And now, let’s delve deeper to understand what we should think about.
Finally, I wrap up this analysis with some helpful advice.
What Happened to Lithium?
After sizzling higher in 2022, lithium prices have fallen 50% in a few months. And prices don’t appear to be finding a floor. Needless to say, this will have a dramatic impact on SQM’s medium-term prospects.
With that consideration in mind, SQM’s share price has actually remained relatively stable. Indeed, as you can see above, despite the pullback in lithium demand, SQM, whose business is nearly entirely dependent on lithium prices, hasn’t really sold off. Why?
Because the market is seeing through this temporary sell-off in lithium prices. The market is looking ahead, and so should you.
SQM’s Medium-Term Prospects
There are two notable drivers for lithium demand. The first one is the most obvious and widely discussed.
As you can see here, lithium demand is expected to increase by 23% CAGR into 2025.
By far, the biggest uptick in demand will come from EV batteries.
Next, I will put a spotlight on another driver for lithium that is less widely discussed.
The Need to Store Energy Off Grid
We are at the early start of the great energy transition. This is the need to decarbonize our world so that we can have cleaner air to breathe. This will see some of our fossil fuel demand coming down, at least that’s the consensus theory.
Realistically, I suspect that what’s in actuality going to happen is that our fossil fuel usage will remain moderately flat, but that our energy supply from renewable energy will substantially increase. More specifically, we are talking about wind and solar energy, the preferred sources of energy in the energy transition.
But as you know, the main drawback of wind and solar energy is that their energy transition is intermittent. There are times when the wind is blowing and times when it’s not. And there are times when the sun is shining and times when it’s overcast.
So, in order to preserve the energy from our chosen renewable energy, we’ll need massive storage power, namely batteries.
Let me put it this concretely, going forward, we’ll be less dependent on a hub and spoke grid arrangement that runs off natural gas and coal, and more dependent on localized renewable energy, in the majority of cases, solar energy.
Think about this, commercial properties and residential properties will store their own energy and replenish local energy networks when there’s an overabundance of supply (capacity).
Let me impress upon you how big the scope of change that I’m talking about is. Did you know that 10% of global energy comes from burning wood? On our planet, 2 billion people burn wood for cooking, space heating, and lighting!
Meanwhile, around the world, only 3% of our total energy supply comes from renewables. Imagine increasing our energy from renewables by 300% so that it matches how much wood we still today burn?
SQM Stock — 7x Free Cash Flow
For the year just completed, SQM made approximately $4.9 billion of free cash flow. Now, let’s assume that lithium prices don’t recover significantly in 2023.
In fact, let’s assume that when all is said and done, SQM’s free cash flow in 2023 is about $3 billion.
I believe that this is a conservative figure. This puts the stock at 7x this year’s free cash flow. Is that really such a high valuation when all is considered?
When I look around the stock market, outside of energy and related services, I don’t know of many areas that are priced at less than 10x free cash flow. And even fewer businesses that have a strong tailwind, which are priced at 7x free cash flow.
Helpful Takeaways
Here’s a list of a few helpful guiding points that help me and that I hope will help you. If you are happy with your current investing process you are welcome to disregard these insights.
But if you feel lost, I hope this may help you. Here are 3 rules that I find helpful when investing.
- Don’t take on leverage. It sounds like common sense, but very few take this advice seriously. Or I should rephrase, it sounds like common sense when stocks fall. But when stocks are going up, few would heed this consideration.
- As frustrating as it may feel, SQM will turn around and go higher. Investing is the ultimate test of fortitude. You have to overcome the massive need for action and hyperactivity. I’m not saying that one should blindly follow your chosen investment process. In fact, on the contrary, it’s vitally important to readjust one’s investment thesis with time. But if the outlook remains relatively stable and attractive, don’t trade out of one position for the next position.
- Finally, I believe that it’s important to be extremely humble when investing. By this, I mean that you should have a 20% to 25% stop loss. I know that this is not what Warren Buffett would do. But neither of us is Buffett. Accordingly, it’s important that we put in place measures to protect our principle.
The above three bullet points are investment strategies that work to protect your principle, as much as to protect your sanity. Because whatever happens at the end of the day, you need your portfolio to survive, so you have capital and fortitude left to fight another day.
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