Feeding a Hungry China

Global economist and strategist Dr Marc Faber is a super bull on commodities, a view that puts him at odds with the consensus among Australian investors.

Faber is widely known as Dr Doom, but there was nothing of the doomsayer in his presentation I attended recently, the most thought-provoking I have ever heard.

His core strategy, which I subscribe to, centres on the medium-term emergence of China as an economic super-power.

There are about three billion people in Asian economies being integrated into the capitalist system.

The opening of China and other countries after the broader breakdown of communism will change forever the dynamics of the world economy; it is already beginning to happen in trade deficits/trade surpluses of industrialised and industrialising countries: the balance of economic power is shifting from the United States to Asia.

Per capita incomes in China are doubling every 10 years. Rising living standards are driving China's own internal demand needs. This isn't only about China's cheap labour advantage and manufacturing; this is about the long-term effects of rising wealth.

Yet Chinese income per capita is just 2.8% of America’s, and India’s a mere 1.6%. Similarly, Chinese copper consumption per capita is just four pounds versus 16 in the US; Chinese aluminium consumption is four kilograms per person against 22 in the US; and Chinese oil consumption is two barrels per person compared with 25 in the US.

Despite these low per capita figures in the early stages of industrialisation, China is already the world’s biggest consumer of coal, cement, rare earths, aluminium, manganese, steel, tin, tungsten and zinc. It is the sixth-biggest consumer of oil, and even at this early stage in its industrialisation its effect on global energy prices is stark.

Faber points out that there are currently only 14 oil fields in the world that produce more than 500,000 barrels per day, and that all of them were discovered before 1965. Six are in Saudi Arabia. Those 14 fields represent 20% of the world's daily oil production. There 12 fields on the next tier, producing 300,000–500,000 barrels a day, or 6% of global oil production.

Those figures illustrate the enormous medium-term opportunity for liquefied natural gas. LNG is the obvious energy source of choice for industrialisation: it's clean, plentiful, located close to markets, where receiving terminals are being built '” and it doesn't carry the political stigma of nuclear power.

The opportunity for the North-West Shelf partners is enormous. The partners, particularly Woodside Petroleum, are sitting on the single largest potential upside in the entire resource world. We will see a dozen processing trains built for the Shelf, and the direct investment in the operation by the China National Offshore Oil Corporation (CNOOC) is trying to tell you just how enormous this opportunity is. I continue to believe that Woodside is the best 30-year investment among Australian stocks, and this isn't about oil prices: it's about the penetration of LNG into the industrialising Asian countries.

Treasurer Peter Costello may not be great at picking RBA board members, but his decision to block Shell’s bid for Woodside on "national interest" grounds was absolutely right.

I have previously used Faber's graph that tracks commodity prices over 200 years in real terms, and so has BHP Billiton, yet I want to present it again here because I think it's the most interesting chart in all of economics.

You have to ask yourself: What if we are only in the second year of a 20-year rise in real commodity prices? You should ask yourself this because no commodity stock is pricing this outcome. Today's commodity stock pricing implies we are two years into a two-and-a-half year traditional commodity price cycle. The extended "super cycle" theory is simply not believed, or priced in. Australia's leading resource stocks are basically a cheap "option" on the super cycle developing. They are priced for a tradition cycle; the earnings forecasts are traditional, but there's nothing traditional about this cycle.

SOFT COMMODITIES

Faber also believes that the upside in real "soft" commodity prices is as large as in hard commodity prices. Farm commodity prices are at 200-year lows compared with energy prices. Soft commodity prices are starting to move, with sugar, lumber, beef, and grains leading the way.

This is not only about rising per capita incomes driving dietary change; this is about falling global farm production driven by subsidy reduction. It's also driven by farm incomes lagging metropolitan incomes in Western countries, and by the rural to urban drift in developing countries. Not only are developing countries consuming more soft commodities; they are producing less as well. This is particularly the case with China, where the “breadbasket" of Guangjong Province is being taken over by textile factories, so you have a double whammy of farm area falling plus increasing average wealth.

In an Australian context we could be on the brink of a "quinella" for the rural sector, with the drought easing and commodity prices advancing sharply. The Australian farm sector has experienced a decade of pain, yet there's every chance those who have survived are now heading into two decades of "gains". Faber would have you believe that Australian rural property is a tremendous medium-term investment. I agree with that, yet it's a very hard theme to play via the equity market.

The only direct way to gain exposure to rural property price appreciation is via the Australian Agricultural Company (AAC), which owns 2% of Australia’s land mass, and closer to 5% of the rural productive area. Yet this stock is trading at a solid discount to its net tangible assets of $2 a share. AAC is a buy, and may even attract a private equity bid.

I’d be cautious about manufacturers that depend on soft commodity inputs, but be heavily exposed to the soft commodity producers. Interestingly, it seems Graeme Hart is doing that switch right now: selling Goodman Fielder and trying to buy Carter Holt.

I think that the best way to play this theme is to put together a basket including such stocks as AAC, AWB, Futuris, Warrnambool Cheese & Butter, CSR, ABB Grain and Nufarm so that you can at least wash out some individual commodity and company risks via a portfolio approach. I know you can't eat trees, but I would also put through the beaten up Gunns into the mix.

What's good for Australian soft commodity producers is good for Australian ground transport stocks and port operators (Patrick, Toll). It's also good for rural discretionary spending, and the best way to play that indirect theme is via regional media (Rural Press, APN News & Media, Prime Television, Southern Cross Broadcasting, Macquarie Media Group). Insurance Australia Group is also Australia's largest rural insurer, and that is one stock that looks completely oversold.

TOURISM

On the more industrial side, Faber believes tourism is Asia's most promising growth industry. Rising per capita wealth, combined with lower foreign travel restrictions and growth in "value" airlines '” some might call them “discount” airlines '” is driving an outbound tourism boom.

In 1995, just 4.5 million Chinese travelled outside China. In 2004, that number was 24 million. In 2005, it is expected to reach 28 million. Ninety percent of all Chinese tourists visit a casino on their trip, usually within the first few days. That's why I think PBL's move into Macau casinos is a huge long-term winner. PBL may also move into mainland China casino development, and to other Asian regions. Most market watchers seem to believe PBL's price/earnings (p/e) multiple will drop as it starts to generate a larger percentage of group earnings from gaming, I think its p/e will rise because the growth opportunities in gaming are so much larger than in traditional media.

Yet, to really open up regional tourism markets you need "value" airlines, and that's why I think Qantas has a huge opportunity to take the Jetstar model to a new level in Asian markets. The Qantas board meeting this week will be a pivotal one in the airline’s 85-year history. The board have to decide whether to "have a real go", and I suspect they will.

Qantas has Boeing and Airbus fighting to supply next-generation airliners, and the airline’s potential fleet upgrade/expansion couldn't have been better timed. Qantas’s financial position is stronger than ever, and its opportunities for expansion are more plentiful than ever.

The airline’s chief executive, Geoff Dixon, dropped a big hint on ABC's Inside Business earlier this week that he would recommend the board "go for it", and this fleet decision will be the catalyst for Qantas moving into a permanently higher trading range as the market starts to understand the long-term, risk-adjusted growth profile.

I'm happy to buy the airlines and sell the airports. All the upside and leverage is in the airlines themselves. People forget that the next generation of airliner is heavier and causes more turbulence than the current generation. The new Airbus A380 will require an extra two nautical miles of spacing on landing, and an extra minute of spacing on takeoff because of its excessive displacement. This could two aircraft movements per house at Sydney Airport.

I think there are tremendous opportunities for leading Australian companies to expand into Asia, and hopefully more will follow Qantas’s lead. Asia is where all the exponential growth is; sure, it comes with some higher risks, but you have to be prepared to accept those risks.

My core strategy remains unchanged, and that is to emerge from the summer trading slowdown with a concentrated portfolio of genuine, large-cap, global growth stocks ("magnificent 7"). I don't want growthless yield, and nor does Dr Faber, who reckons government bonds are the single worst investment you can make.

People don't understand that commodities are now an "asset class", which is why we are seeing so much head-scratching at the current spot prices. Commodity consumers are competing with "asset class" investors, yet the supply side simply can't meet this combined demand. We are on the brink of solid revisions to first-half consensus resource sector earnings, but more importantly, absolutely enormous upgrades to second-half consensus estimates.

Second-half consensus resource sector earnings estimates are simply in "la la land", and that also means 2005-06 earnings estimates are in "la la land". Here we are with p/e's contracting, yet also on the cusp of 20%-plus earnings revisions.

There's nothing "speculative" here; it's factual. The largest degree of positive earnings revision lies in resources; the greatest transparency of earnings lies in resources; and the greatest degree of earnings visibility lies in resources. It's so far from "speculative" it's laughable.

These leading resource stocks are not "speculative", they're "on special".