Blinkered Bears

It seems to have become an annual event: at this time every year, the resource bears convince themselves that base metal prices have peaked and the bull market for commodities has finished.

This year it is no different, however the chorus appears to be louder than previously. I think it is because the recent falls, from record highs, in base metal prices have prompted some analysts to speculate that we are at an inflection point for commodity price upgrades. The argument is that base case earnings and spot earnings are converging, and that if metal prices continue to fall we could be facing the first potential downgrades for consensus base metal forecasts in this cycle.

It appears the bears are missing the obvious implications of record levels of business investment spending, up 15% in calendar 2005. Capital expenditure by mining companies (up 68%) provided the strongest impetus for that increase. Corporate Australia, and mining companies in particular, have committed to big increases in capital expenditure to fund significant capacity expansions and increases in production. The clear implication is that the peak in production for the big resource companies such as BHP Billiton, Rio Tinto, Woodside Petroleum, Oxiana and Alumina Limited is several years into the future. The point the bears are overlooking is that if commodity prices do peak over the next 12 months or even stay flat '” and there is absolutely no evidence to suggest this might happen'” the peak in cash flows is similarly another three or four years away, due to the production growth peak being that far away.

The resource bears also argue that the supply response being generated through increased capital expenditure, will result in a collapse in metal prices and bulk commodities as future production increases. In the last commodity bull market, in the mid 1990s, supply substantially increased and metal prices did fall sharply. However, the major difference this time is that base metals inventories remain dangerously low, in some cases levels are measured in a just a few weeks of consumption. In addition, the consolidation of mining companies, through merger and takeover activity, has resulted in a significant increase in industry concentration.

The prime example is the iron-ore industry, where three players dominate 70% of the global seaborne trade. Similarly, the top three companies control 45% of global production, and Alcoa, even before a major expansion, produces 25% of the world's alumina. Industry consolidation has brought a new financial discipline and the result is a more measured response to meeting the increase in demand. Further, the severe shortage of skilled labour and equipment has become chronic; there is no quick fix to bringing on new capacity. Ironically, the negative influence of rising industry cost pressures are substantially raising the barriers to entry. The simple fact remains: the mining industry is struggling to keep pace with demand, a decade of underinvestment means companies just can't "turn the commodity tap on".

The current iron ore contract price negotiations are a defining moment for the three iron ore players: BHP Billiton, Rio Tinto and CVRD (Companhia Vale do Rio Doce of Brazil). The Chinese are trying to take over the agenda, trying all sorts of tricks, yet the spot iron ore price continues to trade 20% above current contract prices. This is a defining moment because it is a true test of "pricing power".

PRICING POWER

I seriously doubt that, after 30 years of being "price takers" and slaves to the steel industry, that after just one year of "pricing power" the world’s leading iron ore producers will cave in to the steel industry’s whining, particularly given steel prices are rising globally as international GDP growth beats expectations. I strongly believe the iron ore companies won't surrender the pricing power they've worked so hard to achieve, and that iron ore contract prices will eventually settle 15–20% above existing levels.

I refer the bears to the recent BHP Billiton interim result announcement, when management said: "Our confidence in the demand outlook for the next 18–24 months and higher-than-expected prices means we are able to continue to return surplus capital to shareholders while meeting our needs to continue to expand our productive capacity."

Considering management has rebased the progressive interim dividend by 30% to US17.5¢, this highlights BHP Billiton's confidence in the medium to long-term outlook. I think the importance of the increase in the dividend is being totally underestimated. BHP Billiton is sending a very strong statement about its confidence, in not only the longevity of the commodity cycle but in the expected strength in future earnings. The corporates are saying the exact opposite to the analysts that are negative on the commodity cycle. I'd be listing to the corporates again.

There is little doubt that over time, the rate at which base metal prices are increasing will slow from the current frenetic pace. I expect the next re-rating for resource companies will coincide with increased levels of production and the subsequent increase in the return of cash to shareholders. At the same time, I think this will also differentiate the relative performance of mining stocks '” from those companies that are solely benefiting from higher base metal prices, in favour of those that are committing to increases in future production levels.

My resource strategy is heavily tilted to companies with solid production growth over the next three years, and I think the market continues to underestimate both production growth, and average received commodity prices.

It also seems that investors need the comfort of earnings upgrades to keep faith in the sector. I've had a look back at last year's consensus earnings forecasts for BHP Billiton and Rio Tinto, and it points to an interesting analytical trend.

At the end of every quarter every resource analysts works out what commodity prices have averaged for that quarter and write up ''what if" earnings numbers for the bulk resources names. But they don't actually upgrade that first day of the new quarter, they wait three weeks or so for the BHP Billiton and Rio Tinto quarterly production reports so they can punch in the production numbers, combine them with the average commodity prices, and '” presto! '” you have consensus earnings upgrades.

People forget quite how sharp the upward earnings revisions have been. It was only September last year when most analysts had Rio Tinto making $US4 billion for the 2005 year and instead they came in with $US5.2 billion only four months later, which was smack in line with the "new" consensus at the time. Between September and February this year, brokers had upgraded their 2005 forecasts for Rio Tinto by 30%.

If you look in the graph below, the red lines are roughly when the quarterly production reports came out. Note how the upgrades really get going post the production figures every quarter, then continue to dribble higher as people upgrade their commodity prices over the period, after working out they are too low. It's basically not earnings forecasting, it's a kind of known earnings estimation based on historic commodity price and production data. As far as I can see, there's no "forecasting" to any of this, and that is why we can still make money in these stocks by having a strong medium-term view.

RIO TINTO'S SHARE PRICE

BHP BILLITON'S SHARE PRICE

These are the world’s leading resource companies, and the analysis of them remains very moderate in my opinion. Recommendations change every few months '” a first-year economics student could get average received commodity prices and production reports then work out an earnings number after the event. But you won't make money as an investor looking at these companies in this way. Just look how incorrect consensus earnings were when these people had their first shot at "forecasting" 12 months out, and then realise the medium-term opportunity that is still present in the forward years in both these stocks.

My view remains that 2006-07 consensus earnings for both Rio Tinto and BHP Billiton will prove 25% too low, which means both share prices have 25% upside even on a short-term view.

Use the current period of trading volatility as an opportunity to again accumulate high-quality, high-grade, high-production growth, high-ROE, high free cash generation, debt free, Australian resource stocks.

I'm often accused of looking at the resource sector through "rose coloured glasses", but I think I'm basically a "realist", rather than the consensus "pessimist".

I think most domestic investors are scared of the volatility in the resource sector, and are using historic performance as their guide to future performance. Investors continue to believe resources are "trading stocks", not long-term pension fund-style investments. That's the part I totally disagree with. I think many leading and mid-cap resource stocks have clear pension-style investment attributes, albeit with higher short-term volatility than the average pension style investment.

In previous cycles, leading resource stocks had both commodity price leverage and financial leverage, yet here we are today and the sector is giving capital back by the bucket load, and is effectively "debt free". The financial leverage is gone, and therefore the only real risk you have is to commodity prices. Yet as I attempt to emphasise above, from this point, earnings and cashflow growth will be more driven by production growth than commodity prices, and that reduces the overall leverage to spot commodity prices.

I believe that the average resource stock is lower risk than they have ever been, due mainly to stronger financial discipline, and an emphasis on effective capital management/capital allocation. These are totally different animals to previous cycles, yet the market still sees them as the same old "boom/bust" trading stocks.

My resource strategy is not for the faint-hearted. You are going to have to tolerate semi-annual periods of feeling you're completely wrong, but if you can cope with the short-term trading volatility, the long-term rewards in terms of capital growth, dividend growth, and capital management growth will be enormous. I'm still of the opinion that this commodity cycle came just too close on the heels of the "tech boom", which has bred a generation of sceptical investors. That scepticism provides the long-term investing opportunity.