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I’ve had plenty of conversations in the past few days with investors along the lines of "surely the issues at BlueScope Steel de-rail your iron-ore bullishness".

Absolutely not is the answer. I continue to believe the iron ore contract prices in 2006 with the Japanese steel mills will rise by 20%, with the negotiations completed early '” before Christmas.

This is all about grade, and certainty of large-scale supply. It has absolutely nothing to do with the earnings outlook of BlueScope; it's more to do with the Kyoto Protocol, continued demand from the BRIC (Brazil, Russia, India and China) economies, and the fact the best economic returns from steel mills come when they are run at full capacity.

Few people realise it, but the Kyoto Protocol on emissions is driving the price of all "high-grade" raw materials higher. This is all about efficiency and reducing emissions, and the way to do that in the steel industry is via the highest-grade raw materials.

Those who have been to mainland China will know the importance of reducing emissions, and cleaning up the air before the Beijing Olympics. Air quality is a huge problem in emerging Asia, and there is a top-down drive to improve it. This top-down drive is to the benefit of high-grade raw material producers and to the detriment of lower-grade producers.

Investors must be aware of this, and you are going to see an increasingly wide price differential between different grades of the same raw material/commodity. The simple fact is, from this point, the higher the grade, the higher the price.

In the resource cycle to date, low-grade/high-cost producers have outperformed high-grade/low-cost producers because of the leverage the high-cost producers have to the first leg of the commodity cycle. From this point, it seems a far smarter strategy to rotate from high-cost producers to low-cost producers as the premium for high-grade product widens.

Quite frankly, from this point, it's all about owning the highest-grade, lowest-cost, longest mine life resource assets you can, and the vast bulk of those investment attributes are to be found right up the market cap food chain.

Interestingly, the vast bulk of these stocks command price/earnings discounts to their lower-grade peers because they have lacked the higher leverage of the lower-grade peers, and therefore lacked the same degree of earnings per share (EPS) growth.

Yet, investing isn't all about EPS growth, it's about the overall price you pay for the suite of assets, the cash-generation of those assets, and longevity of their earnings.

In my mind, smaller and mid-cap resources generally look expensive relative to their big-cap diversified peers, and it clearly looks like the better value, and potential leverage, is now right up the market cap food chain.

Over the past few months we have seen a plethora of operational disappointments from small and mid-cap resource stocks, and it's a clear reminder of the risks of single or dual mine companies.

It appears the market has put too high a price on short-term EPS growth, and hasn't risk adjusted the price/earnings multiples to reflect the clearly higher risk of less diversified resource companies.

This doesn't mean we need to sell every mid and small-cap resource stock; it just means we need to be very selective. The rising tide has lifted these small ships a lot faster than the big ships, and we just need to be very certain our small ship is "seaworthy".

For example, despite suffering operational issues and earnings downgrades, BlueScope Steel has strong returns, exceptional cash flow, a healthy balance sheet, and appealing growth prospects. The shares look very good long-term value and it seems only a matter of time before consolidators take advantage of low equity market valuations. This has played out in the raw materials sector and it seems increasingly likely downstream in steel. With a wide-open register, regional downstream leadership, and surplus cash flow, I believe BlueScope remains a sitting duck.

If the premium for high-grade is about to widen, it also means that cash generation for high-grade producers is underestimated. I'd be pretty certain that the 2005-06 and 2006-07 cash flows of the high-grade iron ore and high-grade coking coal producers are underestimated, and on that basis, all the investment multiples are over-estimated.

If all this proves correct, then companies such as BHP Billiton, Rio Tinto, Wesfarmers, and even Woodside Petroleum, remain grossly under-valued on a medium-term view. I'd be happy to have 25% of a portfolio in these four stocks alone (ASX200 combined index weight 14.5%).

Many would say that's too large a bet; but I think the next leg of the equity market cycle is all about concentrated bets. It's about genuine "high conviction" investing. Just remember, the ASX200 is one of the most bond-sensitive benchmark indices in the world, and we want a portfolio filled with the beneficiaries of rising bond yields that are reflecting better than expected global growth. Not vice versa.

Price differential for grade is going to become a feature of commodity markets, and I think it will prove unwise to be under-exposed to the highest-grade, lowest-cost, longest mine life, producers.

I expect the pending iron ore negotiations to be the catalyst for the market re-thinking how these high-grade stocks should be priced.

Everything I write above is a positive for the West Australian and Queensland economies. Although the recent AGM season has pointed the finger at New South Wales as the "laggard" state, and I think that's fair, conversely, the outlook for Queensland and Western Australia gets stronger by the day.

It's pretty simple: you want as much direct West Australian and Queensland exposure in your portfolio as you can find, and I think the corporate world is also starting to think like this.