Summary: Mining company returns are highly dependent on commodity pricing, but some brokers are only focusing on prices and completely missing the bigger picture that output and costs are key. BHP is a prime case study.
Key take-out: In the face of shareholder activism, it’s important for all investors to retain and use their voting rights.
One of the great traps in analysing broker reports on mining companies is that they base their profit estimates on what they think is going to happen to commodity prices.
And so, you might have a company that is expecting higher output and lower costs, where the broker forecast is for a profit fall rather than a profit rise. Alternatively, of course, if the analysts are bullish on minerals, a company that is in all sorts of bother with output and costs can be registered as likely to have higher earnings.
The best illustration of the absurdity of these practices comes with our largest non-banking company, BHP Billiton. BHP has been reducing its costs dramatically while lifting output. Last year the institutions forecast that 2016-17 would be a great year, but they were a bit optimistic.
But then, in the current year, 2017-18, BHP was forecast to go into a steep spiral downwards with revenue and net income slumping. And the decline was forecast to have continued into 2018-19.
From those figures you would think that BHP CEO Andrew Mackenzie was falling asleep at the wheel, but in fact all that was happening was that the analysts were forecasting lower prices for iron ore, coal, and copper. Now, as we know, they were wrong and the markets for these minerals have risen strongly. So suddenly the analysts have completely recast their 2017-18 estimates for BHP and instead of falling it’s going to rise on the previous year. Analysts are now forecasting earnings per share advancing to around US188 cents, and I suspect the actual figure might be higher.
Ah, but wait. The forecast decline is merely being deferred and next year, in 2018-19, BHP revenue is forecast to fall and earnings per share to decline to US150 cents, and then fall again to US140 cents in the subsequent year.
Again, the decline is all about analysts forecasting lower commodity prices and not a change in BHP’s output or costs. Now, this week, I see that a number of institutions are increasing their forecasts for 2017-18 and they are not forecasting a big fall in 2018-19. Accordingly, the consensus figures are likely to be adjusted again.
The simple situation is that the strong Chinese economy and the emphasis China has now placed on high-quality iron ore and coal has transformed the price outlook and caught the institutions completely flat footed. It would be so helpful if institutions and brokers made their forecasts on the basis of the current mineral prices and the prices received in, say, the last six months, because you at least then know the underlining situation of the company.
BHP shares have been soaring as the market readjusted to the mistakes made by the analysts. But the misforecasts can have very nasty side effects.
The Elliott wave
Elliott Management, the biggest activist hedge fund in the world, came out to Australia last year with an assorted set of ideas, many of which were total rubbish. For example, they wanted to merge the UK and Australian BHP entities, creating a huge tax liability and reducing the ability of BHP to pay franked dividends to Australian shareholders. And yet, a number of our local institutions actually backed Elliott, probably because they looked at the false profit forecasts and saw them falling without understanding the background. BHP shareholders are very lucky that their management board stood up to Elliott.
The Elliott people also wanted BHP to sell its shale oil and gas interests in the US and get out of them straight away. Again, really stupid stuff. BHP has always had the shale as a long-term sale but needed to rationalise a number of tenements, and this would take time. BHP was also a bull on the oil price and has been vindicated. The BHP shale operation is worth a lot more now than it was when Elliott was spruiking a quick sale last year.
Understand your voting rights
In this context I want all those holding BHP and other shares in self-managed funds and/or in personal portfolios to understand that their voting rights are important.
If you have your holdings managed by others and you are happy with that arrangement, that is fine. But make sure you keep your voting rights, because we have a situation where the institutions are not doing their homework anymore. Many of them are moving to portfolios that simply follow the index and, as they do that, they become less and less interested in the strategies of the various companies.
But they still have voting rights and so can be easily manipulated by crazy ideas from groups like Elliott. Worse still, they often outsource the decision as to how they should vote on matters like salary packages and other issues. The so-called decision-making advisory firms are handling hundreds of companies and sometimes don’t do enough work.
Sanity in the corporate area is increasingly going to be relying on smaller shareholders. That is why it is important that you do your part and not only retain your voting rights but take care in exercising them. If a board and management are performing well, be very reluctant to upset the apple cart by making them revise all their salary structures. The situation is entirely different if they are performing badly.
Chaos and the greenback
Finally, the US tax package is doing all that we expected for the American economy but the US dollar remains depressed, and one of the factors causing this is that people feel an instability in the American political system and its President. Moreover, its protectionist policies are also not engendering confidence in the US and that is affecting the US dollar.
But, of course, in his election campaigns Donald Trump said that the US dollar was too high. In terms of boosting the US, the American instability is actually helping a lot of companies, because it is depressing the American dollar.
Trump thinks this is marvellous, although the Russian situation would not want to get out of control because that could spiral the US administration into complete chaos.