Australia's Long March

The ASX200 traded in an 800-point band for eight of the past 10 years, because the world simply didn't realise the strategic cards Australia was carrying. The graph, below, which traces the ASX200 since 1996 tells the story:

What changed? Why did we break out of the trading range? There is one simple answer: China.

The emergence of the Chinese economy as the Asian growth engine was the key factor in breaking Australian equities out of their eight-year trading range, and my view is that we have moved into a permanently higher trading range.

There were clearly other factors at play, such as political stability, excellent macroeconomic management from the Reserve Bank and the Federal Government, excellent corporate management/ corporate governance, a lack of corporate dishonesty, full employment, and compulsory superannuation. But equities are priced off earnings and dividends, and while the factors I mention above do play a role in the overall rating of the asset class, at the end of the day the world is paying higher prices for Australian companies because Australian-based earnings and dividends continue to outgrow the developed world.

Earnings growth and cash flow generation is leading to clear balance sheet improvements in listed Australia, which is actually reducing physical risks. Return on equity figures are rising, gearing is falling, interest cover is rising, and cash is being either returned to shareholders, used for mergers and acquisitions or, in most cases, both. Quite frankly, listed corporate Australia has never been in better financial health. So is it really a surprise then that global investors are prepared to put a higher multiple on our companies?

The world is also paying for our management skill. It's worth noting that on January 24 BHP Billiton reported record December quarter production across the group. It's a little-known fact that BHP Billiton recorded no fatalities from accidents producing that record output. Compare that to what we are regularly seeing on the evening news from West Virginia, Russia, and China. Mining is a high-risk industry, and I think it reflects very favourably on BHP management that the quarter was fatality free.

Yet it's not just BHP Billiton that takes its employees' welfare seriously. Oxiana reported no lost-time injuries in its record December production report. I think these sorts of developments are a factor in why the world is paying a higher price for our equities.

But are they really paying a higher price in terms of price/earnings multiples for our equities, or just a higher share price to reflect higher earnings? In resources, it's clearly the latter, but we don't think that will be the case for too much longer.

I thought it would be an interesting exercise to work out just how under-estimated forward commodity prices are. As I keep writing, nobody believes in the sustainability of current commodity prices, and everyone keeps writing that it's at the peak of the cycle. I find it impossible to believe that 1.1 billion Chinese are getting a taste of semi-capitalist life and will reject it. I believe we are two years into a 20-year march to Chinese capitalism, a "long march" that will deliver unbelievable wealth to countries that feed that insatiable appetite for raw materials. Clearly, there is no country in the world more leveraged to commodity prices than Australia.

In the following chart, I have averaged the top three investment bank commodity forecasters' forecasts for 2005-06, and for the "long-term", and see how far they are from the reality of today's spot prices. The answers are in the table below.

	Spot Price	Average FY06 Estimate	Difference from Spot (%)	Average LT Estimate	Difference from Spot (%)
Commodity
Gold ($US/oz)	559	493	12	387.5	31
Copper ($US/lb)	2.11	1.49	29	1.075	49
Aluminum (US¢/lb)	107	100	7	77.5	28
Lead (US¢/lb)	59	39.25	33	31	47
Zinc (US¢/lb)	97	74.5	23	51	47
Nickel ($US/lb)	6.58	5.44	17	3.75	43
Tin ($US/lb)	3.29	2.975	10	3.15	4
Oil ($US/bbl)	68.08	57.25	16	50	27
$A/US¢	75.31	76.5	– 2	70	7

The point is that we don't even need commodity prices to advance to continue to make money in commodity stocks. If they stand still and hold at current levels, I can expect to see anything up to 30% positive revisions to this year's resource sector earnings, and up to 50% in the future. It's the future '” or outer '” years where you make money, and it doesn't even require some crazy view on commodity prices for us to make another 50% in commodity stocks over the next 18–24 months. It only requires commodity prices to hold at current levels, which nobody thinks they will.

The three forecasters we have used above are the "go to guys" in commodity forecasting, and all consensus earnings forecasts for the sector are set off their commodity forecasts. We live in a consensus world, and consensus is priced in.

I find it amazing that after two years of consensus forecasts grossly underestimating commodity prices and resource sector earnings, that anyone still listens to these purveyors of doom. These guys are forecasting the end of the economic world. For their commodity price forecasts to be accurate, you pretty much need a global recession. If that happens we're all stuffed, so I'm happy to bet against their pessimism again this year.

A lot of this forecasting pessimism is based on the common belief that spot prices are artificially high due to the influence of hedge funds. As I keep writing, our informed sources suggest that hedge funds have been minor players to this point, and the vast bulk of non-traditional commodity demand has come from "asset class" investors seeking diversification away from the US dollar. Nobody seems to have noticed that the entire commodity complex from sugar through to iron ore is moving; this is not a single commodity event as previous commodity booms have been.

These forecasts also pay no attention to the rising cost of physically getting material out of the ground. I believe we're getting to the point where resource company boards are seriously debating whether to physically go ahead with expansions, due to the inflated cost being quoted to them by the contractors and engineers for those expansions. I strongly believe the "supply response" is going to disappoint the commodity bears, and I also think the contractors and engineers need to make certain their "profiteering" doesn't backfire in the medium term.

Ask yourself the bigger question: 'What if hedge funds do get involved in commodities in a huge way?'. What happens then?

Simply playing this "reality" vs. "denial" arbitrage in BHP Billiton last year would have made you 45%. That's a 45% return in a company that is almost 10% of the ASX200 index. I think that something similar could happen again this year, and the start of that re-rating will be the announcement of a 20% lift in iron ore prices for the Japanese financial year. BHP Billiton will see $30 this year, and $34 in 18 months.

It continues to surprise me that investors continue to pay Macquarie Bank $100 million in up front in fees, and then wait 15–20 years to see if they got a good deal or not, yet they won't even price BHP Billiton on spot commodity prices one year out. The "bubble" is in infrastructure stocks, not resources.

The 10-year ASX200 chart says hold, don't trade. It shows the dangers of "over-trading" in the past two years. If you sold in the hope of buying back at cheaper prices you only had two short periods to replace that stock. More likely you sold and watched the stock trade higher. For eight years trading ranges worked; now they don't in my opinion, and over-trading will cost you performance.

If you want performance, you have to have a longer-term "holding" strategy that involves five to 10-year investment horizons. I am a broker, and I am encouraging you to trade less, and concentrate your bets in a lower number of high quality, high return-on-equity, stocks. Australia is becoming an investing market, not a trading market, and that's what many professional investors fail to recognise.