Fly to Quality

I spent the weekend in the Hunter Valley Between visits to wineries, where I heard constant laments about the current trading conditions, I decided to start re-reading what I consider the best investing book ever written '” One Up on Wall Street by Peter Lynch. This book was published in 1989 yet I regard it as more relevant today than ever.

I like to re-read what I consider "timeless" investing books during periods of high volatility in markets. I like to remind myself of the fundamentals on long-term investing, when it seems everyone is focused on short-term gains/trading/momentum.

You can infer from the current extreme volatility in equity markets that chronic short-termism and instant gratificationist activity has taken over. I see plenty of what I would describe as "performance chasing", and little of what I would describe as "investing".

The biggest indicator of this is that we never have a flat index day any more. If we are not going up, we are going down, and vice versa. It seems the market has become so short-term and so desirous of instant returns that it can't tolerate a single flat index day.

As implied in the sub-title, How to Use What You Already Know to Make Money in the Market, Lynch's book is all about how to identify superior companies, using your own life experiences to identify these companies before the "herd" does. As Lynch writes: "Whether it's a 508-point day or a 108-point day, in the end superior companies will succeed and mediocre companies will fail and investors in each will be rewarded accordingly."

Sure, there are periods when mediocrity and risk outperform, but in the end, superiority, duration, and quality are the investment attributes that generate the largest long-term returns. As you know, I've been writing for the past month that it’s time to get your investing house in order. It is time to lower weightings, or dispose of, short-duration, leveraged, high-risk, mediocre companies, the ones that lead bull markets. It is time to lock in the outperformance of low-quality, short-duration, high-risk, leverage, and rotate to long-duration cycle-beaters who are cheap by comparison as their scale has reduced their perceived leverage and headline growth rates.

The mistake the market will make through this trading correction/ risk adjustment phase is to see it as a buying opportunity again in low-quality, short-duration, high-risk companies. The truth is this is a selling opportunity in these companies, and a buying opportunity in our highest-quality, long-duration, cycle-beating companies. This is the market giving you a chance to buy high-quality, long-duration, superior companies cheaply. Don't mistake it as a buying opportunity in high-risk leverage, as most people will.

Remember, the time to truly add "risk" was three years ago when risk was cheap. Now, we've seen many high-risk stocks in the resource space add 1000%. The broking community is, as usual, very late on the scene, and now recommends the highest leveraged resource companies, and has upgraded commodity price assumptions to justify current share prices.

Much of what Peter Lynch writes about revolves around human psychology, and its influence on the investing process. He says the average investor continually passes in and out of three emotional states; concern, complacency, and capitulation.

He also believes the personal qualities required to be a successful investor ought to include patience, self-reliance, common sense, a tolerance for pain, open-mindedness, detachment, persistence, humility, flexibility, a willingness to do independent research, an equal willingness to admit mistakes, and the ability to ignore general panic. It's also important to make decisions without complete or perfect information.

That's absolutely right. The best investors I've ever dealt for have a calmness yet steely focus I can't describe accurately in words. They rarely own low-quality companies, and they always leave a small amount on the table for the next guy. They are risk takers, yet they are "educated" risk takers. They use broker research as a tool of broader sentiment, and realise the vast bulk of it is "after the event". They form their own views, and while they get a few wrong, they back their own views.

So I want you to think like Peter Lynch through this volatile period, and focus solely on "superior" companies. I want you to emerge from this period, which may well last a few months, with a portfolio of truly superior returns companies. That does not mean only "mega-caps"; it also means superior return mid- and small-caps, where they are appropriately priced.

Manifestly busier

I’ve been a regular visitor lately to the Port Hedland Port Authority website. No, I am not doing surveillance work for Al Quaeda, I am exploring the figures contained on the site, which show how much the demand for one of our greatest natural resources has changed in such a short time.

Links from the Port Authority’s home page list the monthly volumes and destinations of the various cargoes from Port Hedland for the past five or six years. Iron ore is the biggest item, and Port Hedland is BHP Billiton's only major export port for their West Australian iron ore.

The data shows that in April 2004, 1.8 million tonnes of ore was shipped to China. By April 2006 that figure had grown to 5.3 million tonnes '” in two years the output of iron ore to China from this one port almost tripled.

Considering such volume growth gives an idea of the strength of the commodity cycle. Iron ore prices are not going down 20–30% in the next few years, the consensus forecasters predict. If anything, we believe they will continue to head upwards. You will remember that I wrote the other day about how my iron ore "sources" had indicated that even after this year’s 19% price rise, there will be another 10% rise in 2007, 8% in 2008, and then prices will be flat in 2009.

Most big broker analysts will wait until the next quarterly production report to see what the big two resource companies. BHP Billiton and Rio Tinto, have produced for the previous three months. The Port Hedland Port Authority website gives a preview, by showing the volumes being handled. Who cares if production is one or two million tonnes light here or there, due to weather or rail problems? It is the longer-term theme that is important, which is volume growth up to 200 million tonnes a year within the next three to five years.

Analysts who concentrate on present day figures are missing the main game; they should be writing about the 150–200 million tonne longer-term target '”100% volume growth in iron ore from BHP combined with price rises of up to 30%. This results in some enormous free cash flow numbers for BHP and Rio.

BHP operatives wouldn't even publicly talk about Rapid Growth Project 4 unless they were clearly more than likely to go ahead. It's speculated that privately the Chinese are pressuring the iron ore majors for major expansions to deal with their demand, yet publicly playing the game of talking down prices. The problem seems to be that many analysts only seem to believe the public statements from the Chinese, as they all did when the Chinese were playing games when Rio Tinto was below $70 and BHP below $25 a few months ago on worries about Chinese iron ore customs tariffs, which again turned out to be just a game.

The Chinese can talk about the current 19% increase being "unacceptable", but their problem is that you can't turn off blast furnaces as you can turn off an oven at home '” even small ones can take between three and six months to fire up again. There is no way the Chinese will let that happen, and the ships heading out from Port Hedland ain't carrying Akubra hats; they’re loaded with ore.

This demand growth from one major port should highlight to people how real this iron ore demand from China will be for the next 10 years or more. There is no way major Chinese corporates would be backing emerging producers like Gindalbie Metals (Ansteel, the second-largest Chinese steel company taking 50% of their project), or Citic Pacific buying into a $3 billion greenfields development if they weren't expecting ongoing significant demand growth in the next 10 years for iron ore, even after taking 300% more volume in less than two years from BHP in Port Hedland alone, with significant volume increases yet to come.

It's also interesting if you look at where the ships are taking the ore from Port Hedland. Ten years ago I believe 70% would have been going to the steel mills of Japan, Korea and Europe. But when you look now, those customers are well down the list, with China clearly the dominant player by a factor of two or three times, and clearly going higher. I'm sure that in coming years India, although currently a significant iron ore producer, will be keeping more and more production in-house and clearly the low transport cost to India will see more and more Australian exports to India in the next five or 10 years.

Oresome

To see how much BHP has changed you should look at the BHP Billiton iron ore magazine, Oresome. There has been on ongoing target of 29 million tonnes of iron ore production for the June quarter. Clearly, due to cyclones and other issues that won't quite be met, but can you imagine the former BHP workforce, with highly unionised labour and regular strikes, sending emails to management with ideas on how to improve efficiencies in all parts of the business to achieve their targets? It's an amazing change, and this simple example shows how much the whole attitude within the company had changed. "Cultural change" is one of the strongest investing themes you can back, particularly when that cultural change is based around an incentivised workforce, seeking efficiencies, without compromising safety.

I remain a massive long-term bull on the Australian iron ore industry, and believe that the barriers to entry and returns will only be surpassed by one other industry in the long term: liquefied natural gas (LNG).

There's a great Peter Lynch quote about irreplaceable assets in One Up on Wall Street. Lynch says: "There's no way to overstate the value of exclusive franchises to a company or its shareholders. Inco is the world's great producer of nickel today, and it will be the world's great producer in 50 years. Once I was standing at the edge of the Bingham Pit copper mine in Utah, and looking down into that impressive cavern, it occurred to me that nobody in Japan or Korea can invent a Bingham Pit. Once you've got an exclusive franchise in anything, you can raise prices."

That's a great call, and it's only when you physically visit, for example, the iron ore mines of WA that you realise these are truly irreplaceable assets. You realise the barriers to entry are so high that there is a long-term value that's hard to quantify. You realise these are truly long-duration assets, that will still be producing high-grade iron ore when we are pushing up daisies. When you see these assets with your own eyes, it's the scale of them that you simply can't get out of your mind.