“For it is, so to speak, a game of musical chairs – a pastime in which he is victor who secures a chair for himself when the music stops” – (John Maynard Keynes).
Over the past decade, local resource shares have carried the wooden spoon on the JSE, yet over the past 3 years, the annualised return for the JSE Resource Index has been 7 times that of the JSE Financial and Industrial Index. Such a change in fortunes has catalysed resource disciples into full song. Is this the time to buy resources, or is owning resources a game of musical chairs where most of the players end up without a chair when the music stops?
We take a pragmatic and high level look at a very diverse and complicated industry, appreciating that we cannot consider all its facets here. At the end of the article we summarise our findings in a table.
The bull’s argument for owning resource shares:
- Mining is the first stage in the global production value chain of goods and services and thus represents the axis for all value creation.
- Population growth will underpin ongoing demand for commodities.
- Emerging markets continue to urbanise and industrialise feeding demand for commodities.
- ‘Reserve replacement values’ are falling, implying that the depletion rate for many resources is higher than the degree to which reserves are being replaced.
- ‘Reserve sufficiency ratios’, being the finite limit of resources, are declining, i.e. global available reserves of various commodities are dropping.
- Every commodity is finite and becoming genuinely scarce to find, consequently, the cost of production should rise over time and so too the price.
- The world’s largest commodity user, China, has for the past few years engaged in pollution reducing policies. As part of this strategy, it is seeking higher quality resources
The bear’s argument for avoiding resource shares:
- The capital intensity of the industry is increasing, this entails larger capital risk for shareholders.
- High profit margins, entices increased production, defeating the profit cycle.
- Mining is extremely volatile due to the inability to predict short-term demand.
- Positive industry structure, such as barriers to entry are irrelevant to profitability as producers always behave as price takers.
- All future economic decisions are based on imperfect and incomplete information – even the technical feasibility study on a mine can prove erroneous. In addition, socio-political
- factors in developing nations, where a significant number of mines are based, such as expropriation without compensation, threaten to undermine entire ventures
How advanced is the current cycle?
To assess the merits of investing into the current cycle, we follow a process of looking at a mosaic of factors to gain perspective.
Magnitude and duration of rally
Since 1998, we can identify 4 commodity cycles:
- The longest lasted 6 years, starting in 2002 – it was long in duration, explosive and considered a super cycle. It failed spectacularly at the onset of the GFC – Great Financial Crisis in 2008.
- Shorter 1 and 2 year mini-cycles started in 1998 and in 2011.
- The latest commodity cycle has lasted 3 years with gains much in line with other mini-cycles.
Neither the length of the current cycle nor its magnitude are obvious points of difference relative to anything seen before it – this cycle’s price activity offers limited insight into risks or current opportunities.
Although most commodity prices have been significantly buoyed off their 2015 lows, adjusting these for inflation, shows that prices are not absurdly high. In addition, resources are not a homogenous grouping and performances are quite disparate. Bulks like iron ore have rallied hard while some of the base metals, such as copper, have had more muted results.
In nominal terms it is easy to argue that the individual commodity price movements have been significant (iron ore was $37 a tonne in 2015 versus $80 a tonne currently) yet in real terms (adjusted for inflation), the degree of gains are muted.
Company profit margins
EBITDA or profit margins are currently at elevated levels and these margins inevitably mean revert (they return to an average) – mining companies are presently thriving, considering this is a boom and bust industry, we see this as a good reason to be cautious!
Returns on capital employed
The returns that resource companies are earning on their capital employed has reached long-term average levels, thus not incentivising for extra capital commitment and potential shareholder destruction. The risks to returns on capital is a sudden demand shock.
One of the many methods we use to value commodity companies (albeit in this case very rudimentary) is price to book. On this metric, the companies do not look expensive. Coincidentally, they also do not look overvalued on cash flow or earnings metrics.
If there is one lesson we have learnt about investing in commodities it is that predicting short-term demand is a fool’s game. China is the dominant global consumer of commodities and affects pricing (see Figure 7 showing Chinese GDP growth against the copper price), so predicting demand, involves predicting China. Demand is predictable over the long-term and is a function of an economy’s GDP growth and the intensity of their resource usage and per capita incomes. China should remain elevated on these measures against other countries in the years ahead. Our concerns include the trend in Chinese GDP growth since 2008 and the extent to which the government has had to intervene to keep the train rolling.
When China accounted for 10% of global commodity consumption in the early 1990’s, their growth became a free option to resource companies. Now that China represents at least 40% of resource consumption, the ‘white knuckle syndrome’ applies to suppliers. We struggle to see another economy that can take the slack in the commodity market if China has an unexpected shock.
Time to buy?
So how far into the game of musical chairs are we? These cycles are enigmatic and in the short-term predictions are a lottery. However, what we know is that the resource industry is one that, with clock-work precision, displays mean reversion. Consequently, the lowest risk opportunity to own commodity stocks occurs when commodity prices are rock bottom and suppliers are generating poor returns off their installed capital bases with weak profit margins. Our work shows that this is not the case at present.
Performance over time
Figure 9 asks the question, even if an investor missed a commodity cycle, in the long-term, does it really matter? Since 1986, resource returns have lagged the MSCI World Index whilst the risk taken by resource investors has been higher, both in terms of capital draw-downs and volatility.
Our investment philosophy is ‘quality at a reasonable price’. In terms of measuring quality quantitatively, it is evident that relying on a consistent ROIC (Return on invested capital) and FCF (Free cash flow) history in the context of mining, is inappropriate.
We do look to other measures in our quality framework. Commodity companies with proven management teams, that operate at a low point on the cost curve and that possess fortress balance sheets able to withstand the rigors of down cycles, will be considered seriously by Northstar Asset Management as portfolio holdings. However, we remain firmly of the view that commodity investing is about timing and the most opportune time to buy these businesses is when the commodity cycle is in its infancy. We do not believe that is the case currently!
We conclude with a table of our findings from this article.