Commodities: The Nature Of The Beast

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(This story was originally written on Monday, 27th October 2011. It was mailed out in the form of an email to paying subscribers on that day. It has now been re-published to make it available to non-paying members at FNArena and to readers elsewhere).

By Rudi Filapek-Vandyck, Editor FNArena

To most investors, BHP Billiton ((BHP)) is pretty much the same as Woolworths ((WOW)), or Westpac ((WBC)), or Telstra ((TLS)). They're all listed blue chips, it's just that BHP's major growth engine is different while the others, Telstra on top, pay a higher dividend. Alas, nothing could be farther from the truth.

As consumers we find it logical to pay attention to intrinsic differences and we probably never question them. Some shoes are for rock climbing, others for running, others for ball room dancing. Unless we're aiming for a prank, we never take our rock climbing shoes to the ball room or vice versa. In a similar vein, a Porsche 911 is ideal for pushing the pedal to the metal on a race track but we would never consider it for traveling via unkempt dirt tracks in mountainous Afghanistan. Usain Bolt is the world's fastest man on the 100 meters, but don't ask him to run a marathon (he probably can do it, but it won't be very good).

Why is it then as investors we tend to treat all listed equities as roughly the same, only dividing them along rough lines of "growth or no growth", "cheap or expensive"?

Surely, just like shoes are intrinsically different, leading to different choices under different circumstances and for different purposes, the same also applies to listed equities?

I think it does. To stick with the themes mentioned in previous paragraphs: I think energy and mining shares are like a Porsche 911, or like Usain Bolt, or like Bolt's running shoes; they're the best choice around when the sun shines, the wind blows in our back and we need to cross the distance ahead in a minimum amount of time. But when darkness falls, the temperature drops sharply and the road becomes rough, filled with unforeseen bumps, holes and barriers, those speedy fastrunners become of little use.

This is how I see listed equities; I try to judge them by their inner character. This is a fast runner. This is a long distance performer. This is a wannabe. This is a has-been. There's also the come-back kid, as well as the growing up teenager, the listless elderly and the misjudged eternal underperformer… Next thing to do is not trying to force Usain Bolt to compete with Ian Thorpe and leaving the sportscar behind when we travel through the heart of Afghanistan.

There is one simple way to illustrate my point. Below are EPS growth achievements from the past three years for a selected number of companies. To show that my inner character analysis extends beyond mining and energy stocks, I have included Qantas which I simply regard as "non-investment grade" by default. In my analogies, I find Qantas of questionable quality even as a short distance runner. Amongst athletes, the name that most comes to mind when thinking about Qantas is Steven Bradbury. To complete the picture, and show how I try to judge these stocks, I have added consensus forecasts for the next two financial years (current year and following one):

ANZ Bank ((ANZ)) Past: -28% / +30% / +8.6% // Forecast:  +5% / +4%

BHP Billiton ((BHP)) Past: +3.5% / -32% / +75% // Forecast: +11.5% / +6%

Santos ((STO)) Past: +30% / -67% / +98% // Forecast: +2% / +2%

Coca-Cola Amatil ((CCL)) Past: +12.5% / +11% / +9.3% // Forecast: +8.9% / +9.9%

Qantas ((QAN)) Past: -82% / +9.7% / +52% // Forecast: +84% / +27%

It goes without saying that profit achievements, or forecasts, are not necessarily the best guide when it comes to share price performances or even total investment returns. BHP shares are now down circa 25% from their peak in late April this year (and that's after a mini-rally from lower levels). The shares are down 20% since January, still below price levels from January 2010, but up more than 84% from late 2008.

Coca-Cola Amatil shares, on the other hand, are up 12% in 2011, plus they pay out more than 4% in dividends. The shares have appreciated more than 70% since bottoming at $7 in 2009. Also, and this might have escaped most investors' attention, Coca-Cola Amatil shares are today up some 20% since the share market peaked in November 2007. The ASX200 index is still down close to 40% from its comparable peak level.

Shares in Santos are still off more than 25% from this year's April peak, the share price has hardly gained anything in comparison with where it was at the start of 2006 (more than 5.5 years ago) but there have been rallies of up to 50% in between!

I think this short summary in share price performance says it all; when the sun shines, you want Usain Bolt in your team ("investment portfolio"), when rain, hail and thunder reshape the dirt road ahead, you're probably better off without him. After all, Santos hasn't exactly been paying great dividends since 2006 and the company will pay out even less in the years ahead as capital is needed to fund the major capex programs ahead.

It's equally important to note that none of all this is anyone's plan or fault, it is simply the inner nature of the commodities complex. Observe, for example, the chart below showing the pricing of commodities over the past 200 years. To me, what stands out are the sharp peaks and the equally sharp falls.

Question: have you ever wondered how it is possible that BHP's share price reached $45 in late 2007 but while its profits are many times higher today, the share price is -four years later- still well below the $45 price level? China's economy has grown substantially in between then and today, many prices for commodities are higher, the USD is weaker, global inventories for many resources are low, so what gives?

One big difference is… investor sentiment.

Back in 2007 we didn't care what we were paying, today we don't want to take on too many risks. The end result is a much cheaper share price on substantially higher sales volumes, free cash levels, dividends and profits for shareholders.

I have come to the conclusion that the best way to view mining and energy shares is as a triple leveraged play. When all factors are pointing into the same positive direction, watch out, because mega-gains might just fall into your lap. If this is not the case, however, it pays a lot more to be extra-careful. Economic data are not necessarily going to show you the way forward.

All commodity producers are automatically levered to global growth, China in particular. But global liquidity and money flows are equally important, if not more. September saw a record net funds outflow from commodity investments. October brought about tightness in trading credits with French banks (major financiers of trading activity in commodities) and Chinese authorities respectively reining in liquidity. The result has been for extreme volatility, and net lower prices.

This doesn't even mention the fact that tightening policies by authorities in China forced smaller companies in the country to seek alternative sources of credit which often ran via inventories of copper which could then be used as collateral for loans. Practices like this simply add another layer of leverage on top of existing layers (*).

Also, and this, watch my words, will be something that will increasingly receive attention in the years ahead: commodity producers, just like every bank or industrial company, develop through stages of maturity. What is too often forgotten is that most producers such as BHP Billiton had it easy as pie during the bull times of 2004-2007, as they basically did nothing different from what they did anyway, but the prices of their products doubled, tripled and quadrupled during that time. Now, that's easy money!

We are now moving into the next phase, when those easy super-gains are no longer on the agenda but when giga-investments are being decided instead. This will change the character and the dynamics inside the industry. All this is not necessarily going to translate into giga-returns for shareholders. Just ask shareholders in Woodside ((WPL)), Santos ((STO)), Beach Petroleum ((BPT)) and most other medium to larger sized oil and gas producers in Australia. Share prices across the sector are today at or below levels of 2006.

This is as good as any other time to point out that when BHP Billiton's board gave the in-principle go ahead for the further development of Olympic Dam, the estimated costs were $5bn. Five years on, now Western Australia has approved the application for the expansion, the total cost estimate has ballooned to $27bn. Anyone willing to bet this will not be the final number?

Mega-investments will also alter profit and loss accounts across the sector through depreciation and amortisation, as well as via maintenance costs and repairs of existing infrastructure. Analysts at Citi in London tried earlier this year to estimate how all this will impact on intrinsic valuations for mining shares. Their conclusion, though far from set in stone, was that valuations will probably drop by 30%, on average, across the board. Today's share prices have been sold down so much, that even if Citi's calculations prove correct, there's still enough upside left to get excited.

However, the underlying message remains the same: it won't go up forever, and any lasting upside probably won't be as high as you would have thought earlier in the year.

It's the nature of the beast, but even then, that nature is arguably already changing today.

(*) I warned about Chinese companies using copper as collateral for debt on September 26th in China: More Than Meets The Eye

(The story above was originally written on Monday, 24 October 2011. It was sent out on that day in the form of an email to paying subscribers at FNArena).

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