Commodity Lessons From the 1990s

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

In this week's Weekly Insights:

– Commodity Lessons From the 1990s
– The Dark Side Of Lower Oil Prices
– Central Banks In The Limelight
– De-carbonising Investment Portfolios
– Rudi On TV
– Rudi On Tour

Commodity Lessons From the 1990s

By Rudi Filapek-Vandyck, Editor FNArena

It's a fairly predictable knee-jerk response that repeats itself time and time again.

Share prices of BHP Billiton ((BHP)) and Rio Tinto ((RIO)) looked undervalued last year when they were trading in the mid-$30s and mid-$60s respectively -well below consensus price targets of $40+ and $80- so now that both have been re-set below $30 and below $58 respectively, surely they must represent excellent value, in particular for longer term oriented investors?

Not necessarily.

As I have argued tirelessly in years past, it is a grave mistake to assume share prices of commodity producers by default will end up at a higher level as long as one takes a longer term view. The principle might work for stock market indices (including survival bias and regular composition changes) and for superior value-creators such as Australian banks and high quality, quasi-monopolist industrials such as Woolworths ((WOW)) and Wesfarmers ((WES)), but one simply cannot apply the principle to the resources sector, no matter what the size or sector.

The Big Australian, BHP, the world's best and largest miner, has shown exactly that in the years past. After rallying from below $9 in 2003 to near $50 on two occasions by late 2007 and in May 2011, its share price merely moved side-ways in the following three years, caught between $30 and $39, until it succumbed to yet another commodities rout sell-down, temporarily sinking below $27 again.

Maybe the most important lesson the BHP share price can teach investors was during the period late eighties-early noughties. BHP shares spent most of their time ranging between $5-$9 throughout the 1990s. By early 2003, just before the Super Cycle Commodities boom rally was about to take off, the price had again weakened from above $11 to below $9.

Time to roll out one of my favourite anecdotes from history: On 12 September 1991, at an issue price of $5.40, the Commonwealth Bank of Australia ((CBA)) listed on the ASX. Since that moment, total investment returns for shareholders have been roughly 75% dividends and franking and the remaining 25% stems from share price appreciation. The latter has been strong as shown by the share price which briefly touched $90 last week.

Over that same period, BHP's total shareholder return is nearly 50% attributable to dividends. Given the experience since 2011, and the numbers that belong to the 1990s, it is not difficult to see why investors in BHP shares should keep a close watch on the company's dividend policy and promises, regardless of the "I don't buy BHP shares for the dividends" mantra that is often heard around stockbroking offices across the country.

The good news side of this story is BHP is today one of the most consistent and reliable dividend payers in the Australian share market. Contrary to the banks and so many others, BHP hasn't cut its dividends once over the past decade, including during the depths of the GFC. Instead, those dividends were raised in every single year. They will again be raised in the current fiscal year till June 30 (we don't know by how much).

The not so good news is the intended split off of South32, essentially BHP's non-core operations, and how this is going to impact on BHP's dividend potential. By how much will only become clear once we have more details about the proposed float of these non-core assets.

What we do know is the about to be separated assets are profitable, thus reducing BHP's group profits, and investors will not want to see BHP offloading its debt onto the new corporate entity. So essentially, BHP will be left with fewer assets, smaller profits, relatively more debt and less cashflows to reduce the debt.

Today's board has shareholder returns on its mind, so apart from any impact from the South32 spin-off, BHP will not want to anger its shareholder base by having to reduce its dividends, one presumes. One regularly returning idea in analyst reports is that the company can take on more debt, if it really has to, in order to avoid having to reduce dividends, were commodity prices to stay lower for longer. It can also further cut capex, though that may be seen as a negative by long term investors since it also limits future value-creation. (It is for this particular reason analysts at Credit Suisse remain skeptical about Santos ((STO)) not raising new capital as they believe the company won't be able to fund future growth post GLNG).

In comparison with Rio Tinto, BHP shares have now been de-rated, relatively to Rio Tinto stock, as can be deduced from the respective forward looking dividend yields: circa 5.5% (plus franking) for BHP vis-a-vis 4.8% (plus franking) for RIO. The irony here is the less diversified (no crude oil and gas) of the two is able to offer less complications and more shareholder value accretive measures in the short term (analysts are anticipating a higher dividend from RIO plus a share buyback later this month). Also, current projections imply Rio Tinto will return to growth post this year, while BHP is staring at a massive fall in profits this year (-40%), and no growth for the year thereafter.

All of this can serve as an explanation as to why implied dividend yields for both BHP and RIO are now above market average, which truly is a rare event. For comparison: CommBank shares today are offering an FY16 yield of 4.8% (plus franking). Telstra ((TLS)) is offering 4.9% (plus franking). Wesfarmers offers 5.1% (plus franking).

Taking guidance from the past, investors who are buying BHP shares today should be able to generate 7%-plus per annum from dividends and franking, plus an equal percentage from share price appreciation, on average, over time. This, however, negates the possibility things still can get a lot worse, potentially, and if so, this may eventually open up the possibility of BHP having to cut its dividend.

Are we now talking a hard landing for China? Not necessarily, no.

What the 1990s have in common with the situation today is that the 1980s, up until Black Monday in 1987 and the Japanese meltdown two years later, had seen a rapid build-up of cost inflation and higher prices for resources, after which demand growth slowed and supply caught up. Sounds familiar?

What followed next was a prolonged, significant deflation of costs across the industry, which led to a steady decline in prices (in real terms) and a gradual erosion of returns and margins. It doesn't take too much imagination to see commonalities with today's world. Prices for labour, consumables and crude oil are falling while mining companies are all on the hunt for more efficiency, less waste, more financial discipline and a sharp reduction in risk.

As pointed out by commodity analysts at Goldman Sachs, this industry-wide drive for cost reduction is supported by weakening commodity currencies (stronger USD). We can also add the fact that contractors and engineers are in survival mode and probably undercutting each other whenever there's another tender.

The bottom line is this: falling costs means marginal producers can stay in business for longer (see, for instance, the second tier producers of iron ore in Australia), which means prices stay lower for longer, which means margins will come under pressure, regardless of efficiencies achieved. This now has become the base case scenario for the resources research team at Goldman Sachs.

Their forecast is for a repeat of the same industry-wide dynamics that kept the BHP share price mostly inside the $5-$9 share price range throughout the 1990s and into early 2003. On this basis, Goldman Sachs sees further downside for producer costs to the tune of 10-20% by the end of the decade. This is believed to exert further downward pressure on prices. (There are others with similar forecasts, in case you wondered).

One thing to take into consideration is not all commodities are at the same pivot point in terms of supply-demand balances. Prospects for crude oil, copper, coal and for iron ore continue to look unattractive, but the outlook for the likes of nickel, zinc, alumina and uranium appears much healthier. Also, there appears agreement between most analysts and producers that fortunes for copper should gradually improve post 2015. One way investors can seek shelter against the long term downward cycling industry forecast that has now been adopted by Goldman Sachs is by seeking out those commodities with a much healthier outlook. Unfortunately, both BHP and RIO, as well as Fortescue Metals ((FMG)), are at this point of the cycle predominantly leveraged to the less-promising bulks and energy.

To further stimulate debate about this matter, below are some of the charts that accompanied numerous research reports released on this theme by the team at Goldman Sachs.

The Dark Side Of Lower Oil Prices

The global discussion as to whether cheaper fuel is a good thing has taken a nasty turn in January. Major oil producers have been announcing reduced capex while mothballing uneconomic projects, leading to job losses in Australia and elsewhere. But it's the potential second tier and third tier impact from the energy sector's pain that is catching the attention of investors and analysts.

It is often said -incorrectly- the US economy consists of near 70% consumer spending (it's actually 56% ex-healthcare), suggesting cheaper fuel can only be a positive, but what is casually being overlooked is that the energy sector has been one of the key drivers behind the US economy's recovery. And now that same energy sector is out of favour with investors in high yield corporate bonds and doing it tough because of a persistent supply glut and prospects for lower prices for longer.

Turns out, the energy sector and its flow-on effect into the broader economy are important in China too. The Bank of Canada had no qualms and cut interest rates. What about the PBoC? And the impact on the Fed?

Add cheaper-for-longer crude oil with flat-lining spreads in the US bond market, a firmer US dollar and a still reluctant consumer to go out on a spree and what do we end up with?

Downward pressure on US corporate profits.

Market expectations have been pared back significantly since late last year, probably contributing to the US stock market's negative performance thus far in 2015. Equally important is the observation that expectations are now for negative growth in both Q1 and Q2. While this, according to market bulls, creates an ideal platform for upside surprises later, it also creates a potential trigger for a much larger market correction.

After all, no matter what measure used, US equities are not particularly cheap and with general consensus still expecting the US Federal Reserve to move on ultra-low interest rates later in the year, one would be inclined to think that now is not the time for US corporate profits to start showing weakness.

Central Banks In The Limelight

Who would have guessed it?

The year that is widely predicted to see the US Federal Reserve turn less accommodative on official interest rates has taken off with central banks the world around adding more stimulus through either cutting interest rates or loosening currency pegs. I counted at least ten different CBs in action in January, and there's no guarantee I haven't missed a few.

Many of the decisions taken took investors and economists by surprise. This, of course, has directed market attention to some of the central banks that haven't as yet joined the January movement, including the People's Bank of China and our very own Reserve Bank of Australia.

The impact on financial assets is there for everyone to see. Bond yields in Australia already are below the official cash rate of 2.5%, and they keep on falling in Europe and the US where real bond yields (adjusted for inflation) for shorter duration loans are now firmly in the negative. No wonder gold has made a come-back from the abyss (the relationship between gold and negative bond yields is long established, and very powerful, yet it attracts hardly any attention when bullion's fortunes are being reviewed).

The swift change in central bank expectations has also reversed the trend of US equities outperforming the rest of the world. Australian indices are up by near 10% since mid-December, while US indices just experienced their worst January performance since a long time. Note Australia's performance was achieved despite energy stocks and miners refusing to contribute meaningfully. We all know this means… high yielding go-to stocks like the banks and Telstra ((TLS)) are up by a lot more than 10% over the past few weeks.

Central bankers have become the rockstars du jour for investors on the right side of the assets trade-off. This too shall pass, eventually. Just not yet.

De-carbonising Investment Portfolios

On Friday, I called in during an international teleconference around the theme "Climate change – a real threat to asset owners?".

It goes without saying asset managers such as Northern Trust, one of the organisers, are actively seeking an edge that allows its sales people to attract new customers. Any cynic can come up with a dozen nasty comments about how the theme is simply another sales pitch for: how about you start purchasing our expertise? But maybe such cynicism is missing the point?

One thing is becoming apparent and that is the idea to create more climate-friendly investment strategies and portfolios by excluding or otherwise reducing exposure to "dirty" fossil fuels is gaining traction in global finance circles. The concept is no more the sole playground of green activists who largely live and operate outside the world of finance. With mainstream global finance increasingly receptive to the idea (see Northern Trust) investors in Australia should maybe start asking questions such as: how long before this gains enough traction to start impacting on companies including BHP Billiton ((BHP)) and Rio Tinto ((RIO))?

Also, I have come across at least one expert recently suggesting the theme might well have infected future thinking inside the kingdom of Saudi Arabia whereby the prospect of potentially "stranded assets" in the decades ahead is now inspiring the Saudis to pump out more oil in the short term and to defend market share with more conviction than ever before. Better to shift the problem to the rest of the world.

As with everything that spells major change in the future, it remains impossible to accurately predict when exactly green-er investing turns into a massive snow ball with too much momentum to stop it from re-shaping the way the industry does its thing, but this also means it can happen faster and more sharply than anyone is predicting right now.

A bit like the erosion of print media by the Internet. In early 2010, Fairfax Media ((FXJ)) shares were still trading at $1.80. Today, the prospect for Fairfax shares revisiting that level seems very remote. Note also the average share price throughout 2007 was north of $4.00.

Something to think about, surely?

Rudi On TV

This week I shall make my official debut as TV host on Sky Business' Your Money, Your Call. Wednesday, February 4, 7-8pm.

In addition:

– Wednesday, Market Moves, Sky Business, 5.30-6pm
– Thursday, Lunch Money, Sky Business, 12-12.45pm

Rudi On Tour

I have accepted invitations to present:

– Wednesday, 18 February to members of CPA Australia's SMSF Discussion Group in Sydney (evening)
– Wednesday, 11 March to members of Chatswood section of AIA, in Chatswood (evening)
– August 2-5, AIA National Conference, Surfers Paradise Marriott Resort and Spa, Queensland

(This story was written on Monday, 2 February 2015. It was published on the day in the form of an email to paying subscribers at FNArena).

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions. All views are mine and not by association FNArena's – see disclaimer on the website)

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Odd as it may seem, but today's share market is NOT only about dividend yield. Post-2008, less risky, reliable performers among industrials have significantly outperformed and my market research over the past six years has been focused on identifying which stocks, and why, are part of the chosen few; the All-Weather Performers.

The original eBooklet was released in early 2013, followed by a more recent general update in December 2014.

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