Surely The Resource Sector Looks Like Good Buying Now? by Hamish Carlisle, Merlon Capital Partners
When I head out to a group function with old friends and run into people outside financial markets – doctors, dentists, university professors and even CEOs – I invariably get asked what I think of markets at current levels. In Australia, this is a topic centred on commodity prices. Surely the resource sector looks like good buying now?
To these questions I usually take the advice I was provided when prepped for a court case some time ago and respond with the answer “I don’t know” or “it depends”. This response usually solicits a polite laugh and the conversation ends or a polite laugh followed by a “seriously, what do you think?”
The truth is that predicting the direction of market indices is very difficult and from my perspective almost impossible. I think I can form a reasonable estimate of what some individual securities are worth – perhaps within a 50 percent confidence interval – and when these securities trade outside this range I am willing to put capital at risk. This interval is typically much wider for resources companies and lower end valuations are often below zero. Even with this information at hand, I don’t back myself to predict the level at which the most panicked investor would be willing to sell-out or the most exuberant to buy-in.
Generally, people overestimate the precision of their assessments. This behavioral bias is even more pronounced when investors and analysts possess so-called “private information”. I read a report from an investment bank this morning that predicted BHP Billiton would deliver a 42.1 percent return to investors over the next 12 months. I have no doubt that the author of this report has spent countless hours on trains, plans, cars and buses visiting mines, oil rigs, steel mills and oil refineries around the world. Perhaps this is why he is willing to predict returns to one decimal place.
Another truth is that as people we tend to place too much weight on the recent past and not enough on the long-term learnings of history. Hence the question “Surely the resource sector looks like good buying now?”
So what does history tell us about the resource sector? The first point to make is that in the long term resource prices track production costs and over time production costs fall. This is driven by the steady and continuous improvement in mining methods and efficiencies, a trend that can be expected to continue well into the future. In contrast to the observation above regarding private information, this is one insight that could easily be garnered by visiting a modern mining operation and comparing the technologies to those employed just 10 years ago.
The starting point for investing in the resource sector for any meaningful length of time is that the odds are stacked against you – prices generally fall and executives don’t have a good track record of returning cash to shareholders. Here’s a great chart put together by the fixed income team at Credit Suisse in July 2011 showing real (i.e. inflation adjusted) metal prices all the way back to 1850.
Oddly enough, the Credit Suisse equity analyst covering BHP at that time was forecasting a 38.5 percent return to BHP Billiton investors for the 12 months to July 2012 implying a share price of $58. Note that the stock currently trades at $20. Even absent the slow-down in Chinese steel demand that ultimately eventuated, planned supply increases virtually guaranteed a precipitous fall in iron ore prices over a 3 to 5 year time horizon.
To assist in understanding where metal prices sit right now I calculated the inflation adjusted value of the Commodity Research Bureau Metals Index and compared this to the 160 year trend reflected in the chart above.
What is striking about this chart is how high metal prices remain notwithstanding recent falls. Also worthy of note is that historically, after peaks (and metal prices almost certainly have peaked) metal prices almost invariable drop back below trend levels. The exception was following the GFC where we saw almost insatiable demand from China – a scenario unlikely to repeat this time around.
Hamish Carlisle is a portfolio manager with Merlon Capital Partners based in Sydney. Hamish joined Merlon Capital Partners as a Principal in July 2010. Hamish was previously Head of Research, Asia Pacific Equities at AMP Capital Investors. Prior to AMP, Hamish was a Senior Director and Head of Australian Banks Research at Merrill Lynch Equities. He has also held positions at Burdett, Buckeridge, Young and National Australia Bank. Hamish holds a MBA with honours from The Wharton School, University of Pennsylvania and a Bachelor of Commerce with first class honours from the University of Melbourne.