The case for the believers
The case for the resource believers is reinforced constantly through the bullish sentiment from the media, stockbrokers and resource company executives.
Competition for superlatives remains intense as “stronger for longer” is superseded by “100-year boom”, “stronger forever” and “it’s different this time”. The gist of the ‘believers’ arguments is similar, but the central tenet is a demand-led argument stemming from a number of reinforcing factors:
> Chinese economic growth. After an extended period of extremely strong gross domestic product (GDP) growth (it has not fallen below 7 per cent since 1991), growth momentum has increased the confidence among most of the financial community and the general public, that growth will continue unabated. The primary reasons for expecting continued growth appear to be extrapolation in addition to the scale of ongoing capital investment and the ‘once in a lifetime’ industrialisation of the world’s largest population.
> Decoupling. As the slowdown in western economies, particularly the United States, has challenged the traditional commodity price response (ie, declines), the term ‘decoupling’ has been coined.
> India. With the large population base of China being a major driver behind the story, the potential for India’s similarly large population to act as further stimulus for the demand story is logical.
On the supply side, similarly emotive arguments add further fuel for the believers:
> Inability to secure new supply. While arguments on ‘peak oil’ have been around for decades (and yet to be realised), the inability to add supply quickly in many commodities due to infrastructure and labour supply bottlenecks has fuelled concerns over the ability to add supply in the longer term.
The ability of these arguments to elicit an enthusiastic reaction among a large number of investors is obvious. The opposing case for sceptics is perhaps more complex.
The case for the sceptics
Calling into question the structural elements of the commodities boom may be somewhat heretical at present. However, with the confidence that ‘burning at the stake, has been abandoned as punishment I’ll try and make the case for why I believe the boom to be cyclical rather than structural, and prices of resource stocks, in most cases, to be unsustainably high.
Separating the impact of price and volume
In many commodities, the lack of investment in mining and associated infrastructure over time has been a significant factor in the current supply demand imbalance. In some cases this imbalance has been exacerbated by marginally greater than expected growth in demand.
However, price is the important factor in relation to the current imbalance. Exceptional growth in profit, cash flow and return on capital, are almost always driven by price, as this requires no further investment. The complication in forecasting relates to the ability to determine the price at which additional supply will be encouraged, the price at which demand will be destroyed, and how long prices will take to return to equilibrium.
Commodity producers have been enjoying that most gratifying phase of profitability, in which supply has been increasingly squeezed in a broad range of commodities.
Impact of GDP growth
‘Growth’ is a particularly alluring term for both investors and companies although it tends to be poorly understood. ‘Growth’ is an input to the ‘value’ of any business, rather than an attribute that should be sought out regardless of value.
By way of example, a recent article in the UK’s Financial Times, made reference to an investor who proposed an argument that the Chinese stock market may be reasonable value at a PE ratio of 100, or an earnings yield of 1 per cent, on the basis that when GDP growth of 10 per cent was added to this return, a total figure of 11 per cent was more than acceptable, particularly relative to the returns available for alternative Chinese investments.
The assertion that the earnings yield of a business can be added to the GDP growth of the country to arrive at a total return expectation is ludicrous. The GDP growth a country will accrue to both existing and new competitors has little to do with the returns an investor will earn, as it gives no insight into how much additional capital will be required to generate this growth.
Corporate activity — justification or capitulation?
The flood of Chinese capital targeting Australian mining company stakes has further fuelled the current frenzy and some say a justification for current valuations.
Fortescue is a good example. While it’s been an amazing feat to develop the Fortescue business in such a compressed time frame, if one focuses solely on the investment merit at current prices, it’s a case of overvaluation.
Developing the mine and infrastructure has seen capital investment of around $3 billion, however in total enterprise value (debt + equity) the stock market now values this business at more than $30 billion. Investors buying the stock today expecting a return of say 10 per cent will need pre-interest and tax earnings of around $3 billion in perpetuity to deliver this return.
This assumption dictates that the original capital employed would earn a return on capital employed of 100 per cent in perpetuity. Historic evidence and fundamental laws of economics suggest the probability of this outcome is particularly low.
Factors exacerbating commodity prices
Supply and demand imbalances alone are normally insufficient to plant the seeds for a ‘bubble’.
However, the equation is being aided by a number of coincidental developments in the financial industry.
The litany of repackaged and restructured assets designed to lure investors with the promise of attractive or better yet, uncorrelated returns, is never ending.
Even in the aftermath of sub-prime, the financial industry is more concerned with identifying the next hot product than embarking on the process of reform. Commodities trading is a case in point.
From my perspective, there is absolutely no doubt that the entry of long-only investment capital is impacting price in almost all commodity and energy markets, the only question is how much.
The influence of investors such as hedge funds, supposedly providing ‘efficiency capital’ to markets, is less clear.
However, it is likely that these participants will at the very least, amplify volatility in each direction.
These futures contracts will need to be ‘rolled’ at regular intervals, and require an opposing investor to take the other side of the transaction. The only natural sellers of commodities are producers who obviously have a natural limit to their desire to sell forward future production.
If, as is most often the case, trades are executed through investment banks and there is no natural seller, investment banks or other intermediaries will need to hedge the other side of the transaction by eventually accumulating physical product. Every paper commodity investment must eventually be backed by product.
The other contentious issue in explaining the inexorable rise in commodity prices is the contribution of overly easy monetary policy to the equation.
Recent years have seen an almost unprecedented period of coincident growth in global economies, fuelled significantly by extremely strong credit growth.
This booming period of credit growth has facilitated a boom in both consumption and investment.
The balance between consumption and investment varies by economy. Economies such as China have been powered almost solely by an explosion in fixed investment, the US has consumed, while economies such as Australia have been somewhere in between.
The masters of extrapolation are assuming Chinese fixed investment will continue unabated. In my view, economics will eventually apply to this investment. Erecting buildings, steel mills, aluminium smelters and endless other infrastructure projects is only sensible to the extent that end demand ensures these projects earn a sensible return on capital.
Conclusion
These arguments are not intended to represent the rantings of an aggrieved investor who happens to be on the wrong side of a pool of investments subject to powerful momentum, although I will be the first to confess to frustration.
They are intended to lend some weight to the case for investors to consider the possibility that the commodities boom may be cyclical, and that assets in the area may currently be substantially overvalued.
The forces of momentum are powerful and the impact on human behaviour equally powerful, however, it is these factors that should ensure fund managers apply even more rigorous analysis to the allocation of capital to companies in times such as these, rather than succumbing to the path of least resistance.
I, for one, don’t subscribe to the lemming theory of commodity prices.
Martin Conlon is the head of Australian equities at Schroders.
(This article is a synopsis taken from the paper titled ‘Hymns for the non-believer’ by Martin Conlon dated June 2008.)
