Value – Long Time Horizon Required

This story features BHP GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: BHP

This story was first published two days ago in the form of an email sent to registered FNArena readers.

By Rudi Filapek-Vandyck, editor FNArena

For those readers who only know me through my recent writings, the following statement must seem like an odd one to make: soon after I arrived in Australia, now more than eight years ago, I became fascinated by Australia’s resources industry.

This was partly due to the fact that I grew up in a small mining town in Europe. From there I had witnessed from close distance the closure of coal mines in countries such as Holland, Belgium, Germany, and especially the UK under Thatcher. And here I arrived in Australia and one of the country’s major assets included coal.

Not that anyone paid much attention at the time. The tech bubble had grown and burst, the share market was going through a bear market phase and most share market excitement, or so it seemed, was in the slipstream of companies such as Burns Philp, OneTel, Aristocrat, Mayne Nickless and Pacific Dunlop. You will have noticed most of these names are no longer listed at the Australian Stock Exchange.

Already the early foundations became visible of what would later be named the Commodities Super Cycle, but most Australians -journalists, investors and stockbrokers alike- paid little, if any attention to this. Fresh from the plane, I was unfamiliar with the long bear market for resources that had characterised the nineties, and so I picked up the new theme and ran off with it.

After a few early projects I was given the opportunity to initiate a new monthly investment magazine at the local newsagent, The New Investor. After that I started a free online financial magazine. It still exists, in name, but its content bears no comparison to what I and the original team put together in the first three years of inception. Both these projects carried plenty of stories about the re-born commodities.

Those were the days I would open a story with a sentence such as: If you still don’t own shares in BHP Billiton ((BHP)) you must be either Cinderella or an alien.

At one point I was lauded as one of the first journalists who had picked up the resources revival in Australia. When colleague Greg asked me this week whether it was true that Citi analysts had been the first to flag the resources revival I was able to confirm they were certainly among the early ones. I know, because I still remember reading those early reports.

At FNArena too most of the stories, and my personal analyses, that had been published until the middle of 2008 carried an unmistakable positive undertone. When I concluded, in February this year, that Australian bank shares had already peaked back in 2003 and only few, if any, investors in Australia were aware of this fact, I illustrated my point by comparing the share price performance of National Australia Bank ((NAB)) with BHP Billiton’s. BHP shares had outperformed by 400%.

Time to use that famous quote by John Maynard Keynes:

“When the facts change, I change my mind. What do you do, sir?”

In May I predicted those invested in oil stocks would reap huge losses as the speculators bubble would soon come to an end. In August I predicted the worst correction for commodities in human memory.

Even though I could have hardly made two analyses as timely and accurate as these, I feel no bond or allegiance to them whatsoever. If the facts change tomorrow I’ll simply revise my conclusions. One would assume there is a natural temptation to start calling the next upswing for energy and resources. First you call the downturn, then you signal the upturn. Cannot do any better than that!

The problem is that I have yet to see any indications for such an upturn occurring. I can see how building blocks are starting to fall into place that will, ultimately and combined, create the base for the next upturn. But it is way, way, way too early to start thinking about the next leg up for oil, copper, nickel and the likes.

If anything my conviction has only grown further there is more downturn ahead of us still. Most at risk are the laggards of this correction that started mid-year, crude oil and copper, plus the bulk commodities. While further downside for the likes of lead, zinc and nickel should be fairly limited given the heavy falls recorded already (all these metals have fallen much further than securities analysts thought possible) the same does not yet apply to the laggards in this correction (the former leaders whose prices only peaked this year).

Last week I wrote a story about the team of steel specialists at Citi in Europe and how these analysts had positioned themselves among the most bearish in the sector. The problem was their colleagues at the energy and metals desks were not willing to follow the steel team’s lead. Hence why official Citi forecasts remained much, much higher than what the European steel team thought they should be.

Two things have happened since I first heard about this internal schism at Citi at the end of October: other analysts within the financial group have started to bring their forecasts more in line with the steel team’s views, and so too have analysts elsewhere. But more importantly, those analysts who have taken the effort to travel to Latin-America and Asia to get a better insight (and first hand feedback) about what is happening in the world of copper, steel and oil all seem to return in shock. Things turned out much, much worse than they’d thought possible prior to these trips.

Macquarie analysts this week published a report in which they bluntly stated: there’s a new game in town. ANZ commodities expert Marc Pervan instantly turned himself into the uber-bear in the local market, joining Citi’s steel team in their prediction the upcoming contract negotiations for iron ore will likely see prices go back to levels from 2006; this implies a decline of 50% as opposed to minus 20% as most resources analysts, including those at Citi, have been willing to put through their models.

Pervan also has become the first expert in Australia who has had the guts to put in black and white that the price of crude oil will fall through technical support at US$50 per barrel. He even went a few miles further: Pervan believes there is a genuine chance we will see crude oil back below US$40 per barrel, and see it stay there for a prolonged time.

Most remarkable, however, is that various teams of commodities specialists now appear to be cutting price forecasts on a weekly or a two-weekly basis versus a habit of ad-hoc or quarterly adjustments previously. The team at GSJB Were had another round this week, further lowering forecasts for base metals, and the bulks (minus 30% for iron ore). According to my memory they undertook two similar exercises in recent weeks.

The message investors should take away from all this is not to focus too much on whether this product or the other one is predicted to fall by this much or that, but that things in general are turning much, much worse than previously anticipated. And they seem to become worse rapidly in only a short time frame. (This is also related to the fact that analysts are only now starting to gain these new insights).

The underlying trend remains for worsening demand and market conditions for all basic materials. The same trend is apparent in revised projections by economists across the globe. GDP growth forecasts continue to be cut and are now suggesting the first synchronised global recession in a long time. This comes hot on the heels of the first global synchronised super-economic growth. That era only ended in the third quarter of 2007.

As things stand right now, and certainly global leading indicators support this view, the final quarter of 2008 (the current one) and the first quarter of next year are likely to generate absolute horrific economic data. From Europe. From the US. And from China. (Most likely from Japan too).

Two weeks ago I wrote BHP Billiton had now become a $20-something stock. My analysis since has only reinforced this view. I now believe it cannot be excluded that BHP shares will test the $20 price level at least once in the next two-three months.

Future earnings expectations for the Big Australian are largely dependent on what will happen to prices of oil and copper and the bulks; iron ore and coal (metallurgical coal more so than coking coal). If future scenarios as painted by Marc Pervan turn out more accurate than those adhered to by the eternal market bulls, then today’s Price-Earnings ratio for BHP shares might be closer to 10 instead of the much publicised 5-something.

I use forecast for FY10 because it is my prediction that the market will largely ignore what will happen to this year’s results (year to June), as the financial outlook for fiscal 2010 is already pointing towards a significant fall in profits. As such, I think there is more than just a reasonable chance BHP shares might still be trading around current price levels -in the mid-$20s- in twelve months from now.

For those with a trading approach: this should set the parameters for your strategy in the months ahead. For all others: there is no rush whatsoever. “Long Term Value” is probably best interpreted as “at least two years from now”.

If you happen to own shares and your horizon is further than the next twelve months: lucky for you the company does pay dividends in the meantime.

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