Look closer, Mr Costello

October was the sharemarket’s best month for more than five years: the 4.7% increase for the ASX200 for the month was completely unexpected by most commentators and investors, and interestingly the October index return was almost the same as the annualised cash rate.

Everyone was worried about "risk" in September, but it turned out that true "risk" was very low at both and index and stock-specific level.

The corporate and private equity world aggressively took advantage of the market’s "risk aversion" in September, and embarked on an unprecedented shopping spree in Australian equities. That shopping spree is even driving the price of the Australian dollar higher.

I remain of the view that the entry price you pay for a given stock or index decides its true level of risk. If a stock has fallen 50%, or underperformed the index by 50%, then in my mind the true risk is very low. However, the market always seems to believe, due to its obsession with earnings and share price momentum investing, that these stocks are very high risk.

Incorrect. The lowest-risk stocks in Australia in terms of true share price risk are generally all located at the bottom of quant ranking models.

Of course, the market continues to attempt to de-rate the already de-rated, and you see analysts becoming more bearish as share prices fall. The Australian market loves kicking a corpse, and that provides many genuine low-risk contrarian investing ideas. The fact Telstra (TLS) rallied 7% in a month, despite being the most universally disliked large-cap stock in Australia, should remind you that true risk is low in de-rated stocks.

For the third time in three years, Treasurer Peter Costello has called the end of the commodity cycle. For a Treasurer who prides himself on being in touch with the corporate world he must have lost BHP Billiton's (BHP) phone number. Compare the recent BHP annual general meeting commentary versus some of the comments from the Treasurer this week, and it’s pretty clear he must be talking about another industry.

To quote BHP: "The likely outcome of these circumstances is an extended period of high cyclical prices for the commodities BHP Billiton produce. What's happening is that after years of under-investment, the world has rediscovered resources and the critical role they play in our daily lives. Today there are billions of people in developing economies of the world who need natural resources to support their economic and social development. For a variety of reasons, the industry is finding it difficult to respond to the increased demand for commodities. We don't try to predict where commodity prices will be either tomorrow or in the next decade, but we do believe that solid product demand and a supply side that struggles to keep up will characterise our industry in the short to medium term."

BHP Billiton is Australia’s biggest corporate taxpayer; it is the largest stock in most superannuants’ share portfolio; and it is the largest resource company in the world. Yet despite BHP Billiton's crucial role in the Australian economy and its crucial role in Australian wealth creation, it seems the Treasurer hasn't even read the chairman's address from last week’s AGM.

Pete, with all due respect, you are talking jibber. Pete, stop listening to ABARE (aka A BEAR). I urge you again to ring the BHP Billiton switchboard in Melbourne on 1300 55 47 57 (it's a free call), and ask for "Chip".

I would also urge you to stop talking against the national interest. Our major resource companies are about to enter annual iron ore contract price negotiations, which are crucial to the Australian economy, and you are sending a public message to Asian consumers that they don't need to pay a higher price.

How is that in the national interest? The easiest game in town is to tell people "the sky is falling", but what if "the land is rising". We won't see the top of the commodity price cycle until we see the "Chicken Littles" become believers. That will occur in 2008-09, but by then many Australian resource companies will have half their market capitalisations backed by cash.

Company-changing cash flows

The old adage "cash is king" becomes a real problem if you are underinvested in an equity bull market. However it has become a very high quality problem for global resource companies.

The five biggest oil companies operating in the US concluded their earnings reports last week and announced a total of $US31 billion in profits. Exxon was the highlight, reporting third-quarter net earnings of $US10.5 billion.This amounts to $US117 million a day. In line with the massive cash flow generation, Exxon bought back 126 million shares, or 2.1%, for a total cost of $US8.4 billion. The company is on track to return nearly $US33 billion to shareholders through dividends and buybacks in 2006, providing an effective yield of almost 8%. Incredibly, Exxon's 2006 capital management initiatives alone represent 25% of BHP Billiton's market cap.

Phelps Dodge is also swimming in cash after the recent third-quarter result, where cash on the balance sheet increased to $US4.1 billion. Phelps Dodge also has a $US2 billion buyback in place. After a significant increase in capital expenditure, the company is still expected to generate more than $US3 billion in free cash flow this year, or $US15 per share, against a current share price of $US100. If the copper price stays anywhere near current levels next year, about 30% of the company's current market value is expected to be in cash. It is also worth noting that Phelps Dodge intends to close out $US1.5 billion in 2006 and 2007 copper hedging contracts. I find it very interesting that Phelps Dodge is bullish enough to buy back copper forwards, with the physical price at $US3.40 a pound, despite analysts’ forecasts falling to $US2.50 a pound next year.

Rio Tinto continued the trend by announcing an increase in its capital management program to $US7 billion. This represented an additional $US3 billion, after the previous $US4 billion buyback was 80% complete, well ahead of the deadline of December 31, 2007. There is no doubt Rio has used the big UK discount in the PLC shares to accelerate the existing buyback. I suspect the majority of the new buyback will also target the UK register. The increased buyback is a clear endorsement of the strong underlying fundamentals, and a commitment to financial discipline and enhancing shareholder returns.

However, I just don't understand the logic of selling Rio Tinto PLC shares, which trade at an 8–10% discount, into a buyback which is expected to be 3–4% EPS accretive, ahead of further capital management initiatives and earnings upgrades. Brambles BIL PLC previously traded at an even larger discount of 10–12% before the unification announcement. However, the resulting short squeeze has killed the UK arbitragers and hedge funds. I think there will be a similar re-rating for Rio Tinto and BHP Billiton when UK investors finally realise there is no upside in shorting to on-market share buybacks. UK investors have consistently under-priced BHP Billiton and Rio Tinto for the past five years and you will make a lot of money by betting against them.

Excess billions

In a recent report on BHP Billiton, Global leader going cheap, Southern Cross Equities analyst David Radclyffe highlights the company-transforming cash flows using an upside commodity pricing assumption. As a reminder, the December-half average price for copper is $US3.46 a pound, nickel is $US13.46 a pound and oil is $US67.63 a barrel, and our upside case assumptions are actually lower! We believe BHP Billiton could potentially have more than $US18 billion in surplus cash in 2007-08 after the current $US3 billion buyback.

The magnitude of BHPs cashflows, even after significant capital expenditure and returns to shareholders, continues to sharply reduce company gearing levels. BHP has stated that is very unlikely to run an ungeared balance sheet. However, to maintain gearing around current levels, we expect BHP will need to invest/return up to $US20 billion over the next two years. I can already hear the sceptics arguing against current commodity prices being maintained over the next two years. However, analysts’ commodity forecasts have been consistently 50% wrong over the past three years.

The huge cashflow generation and capital management initiatives highlight some key issues for the major resource companies. First: management’s confidence in the continuing strong fundamentals for commodity prices, and the sustainability of earnings. In the recent capital management presentation, Rio Tinto expected the Chinese economy to grow at an average 8% over the next decade. It is amazing; analysts remain sceptical while corporates continue to display confidence in the cycle.

If the commodity super cycle were truly over, then the first casualties would be the pure plays. However, the "one-trick ponies" and second-tier miners are massively outperforming BHP Billiton and Rio Tinto. This is unsustainable. The poor end-of-month performance by BHP and Rio relative to the pure plays this week was a clear indication that investors are still underweight after the correction in August/September. The huge Telstra rally is sending investors a very powerful message. You can guarantee to lock in underperformance by remaining underweight big-cap major stocks when there is excess cash and valuations and fundamentals are positive.

So I am happy to enter the debate on the side of BHP Billton, Rio Tinto, CVRD, Xstrata and Anglo American. The rerating of commodity stocks is in its infancy, and it will as significant an event as the rerating of domestic banks through the 1990s and into today.

We have not yet seen an expansion of price/earnings (P/E) multiples. We have seen P/E compression as the length of the current cycle scares more and more investors. You need to ignore the Chicken Littles, and align your investing interests with the long-term growth engine called Chindia.

You may think I'm joking, but I believe BHP Billiton is now vulnerable to a takeover from a global oil major seeking diversity. Exxon could buy BHP using just four years of cash flow. Did you ever think you'd see the day when BHP was genuinely vulnerable to a takeover? If that ever happened, Pete, you'd be faced with an interesting decision.