Investment Matters

Commodity prices, groan...

There has been much discussion in recent times of the “end of the China boom” - and its effect on commodity prices, as well as listed commodity companies. This talk has picked up as underlying prices have continued to fall (as witnessed below by the commodity price index) almost day-in and day-out recently.  And have now entered a point where the futures' market (i.e. the prices you can “lock in” the purchase or sale of a commodity in the future) has begun to also price in a pessimistic commodity price environment for most commodities. 

BHP RBA 1

It is a general truism in markets that when no one thinks there is any reason to be optimistic (or that prices will ever rise), is probably the point whereby capitulation has occurred (or is occurring) and prices are at their eventual lowest.  We shall see. It could still be early days as I shall discuss.

This time is different, sort of, but not really

Commodities are, by and large, a poor investment.  Always have been.  Always will be.  There is no economic value that can be added (hence “commodity”) and therefore the ups and downs are dictated purely by 1. Supply & demand, and 2. Short term sentiment (or weight of investment dollars).

Commodities are only really attractive if you can buy them when supply is currently less than what demand is likely to be.  Then you have the chance that people will pay higher prices.  This is what happened with the “China” story: much was needed and supply was initially tight. 

A decade on from this position, however, the supply side (for most things) has now risen considerably to a point where it anticipated high growth rates in demand for basic products continuing for a long period of time. This is now being proven to be a poor assumption. 

Supply has adjusted to a picture that is proving to be less exciting

Gone are the days over the past several years where simply securing the commodity was the concern.  Nowadays there is plenty of most things (stocks are generally high in most commodities), and therefore price is now the only issue!

As a result, prices for each commodity (they are all different subtly in supply and demand) have been falling, and will continue to fall until such time as supply “falls out of the market”.  This will move supply and demand more into balance and should be at a price that reflects the marginal cost of supply (i.e. what it costs to produce the last tonne of iron ore that is required to meet demand each year).

The commodity markets are finished… no, but there might still be more downside for some things

At extreme times in every market it is common to see extreme thinking.  Seeing commodity prices fall as they have and seeing all the reporting surrounding it can make it feel like a dying industry.  This is of course not true.  Even in a global recession commodities will be consumed and required.  To provide these, maintenance work will need to be performed and investments in productivity and people made.  Just not as crazily or lucratively as was the case several years ago, when people were scarce and jobs plentiful.

The reality is, however, that the adjustment in most markets will take time.  Given how cheap credit remains globally, the persistence of oversupply will be greater than prior cycles - as it allows expensive supply to hang on (in hope of a turn) longer than it would otherwise be able to. Caution is the name of the game, and further downside is possible.

The rationale for this is best seen in a longer series of RBA commodity prices.  This shows that, whilst we are on 10 year lows, commodities prices can  (we think iron ore will) fall a lot further yet. In addition it is apparent that the share price corrections that have occurred have not actually yet washed out all of the boom period, as some are claiming. As we say, there remains good reason to remain cautious.

BHP RBA 2

First Samuel’s take and positioning

In a general sense we reduced our exposure to commodities several years ago (we sold BHP and RIO completely) in anticipation of the readjustment we are now seeing.  Clients will recall we invested in the insurance industry instead.

We maintained and have built several small positions in suppliers of products/services to the wider industry as they have been priced for resources industry failure and represent compelling value. In time these will deliver strong returns (and boost future dividends for clients) when the dust settles.

We have only dipped our toe back in the water, however, around commodity priced investments.  In February this year we made a small purchase of BHP, and then bought a small position in South 32 (BHP’s spin off) in May.  We retain a small holding in both at this time as we wait to see signs that the underlying commodities for both (BHP is more at risk than S32) have moved back into alignment and hence stabilised.  Both businesses will survive the current commodity rout and will offer excellent returns when the industry settles down.

Pride comes before a fall, BHP…

That said, the way BHP (a small position) is managing its capital, is concerning.

When you are in business as a price taker, and the prices for what you do fall (in most cases by >50%) it seems crazy to run your business as if it never happened and not give its owners an early heads up about how tough things are. 

We estimate that at current commodity prices, BHP will produce around A$0.81c in earnings for each shareholder this year (it did A$1.83 in FY-15). Yet the board is firmly maintaining its progressive dividend policy (that is dividends never go down) which equates to a dividend payout of $1.71ps.  This is 2.1x the level of current profits. 

Now it should be noted that in these conditions, cash flow will be higher than profits as the cost to maintain the business (or capital expenditure) is much lower now than even three years ago (as the weak industry makes the input costs much cheaper).  This means the company may only have to borrow some of the +$3b difference (between earnings and dividends), but still it is apparent to anyone who cares to look that this is both a foolish short term position, but worse, idiotic strategic thinking. 

By accumulating debt in the weak part of the cycle BHP will not be able to maximise the benefit from the weakness in other asset or company prices and buy assets on the cheap to boost future shareholder returns. 

For most investors one of the key lessons of the GFC was the importance of income.  If you always have free cash flow (or money left over every year) you can use that to buy things cheaply in tough times that will boost your returns in good times.  It appears BHP has no concept of this simple logic, which is troubling.

BHP has great assets and is working hard to make them even more productive and valuable for shareholders.  Bravo management.  It is a shame the capital management is so poor (and in fairness has been for a long time now), as it seriously dents investor enthusiasm for future returns.

We assume in our dividend modelling for clients that in the end BHP will have to cut its dividend substantially.

We factor in a (still high) pay-out ratio of 80% (most companies usually pay 60%) which on today’s earnings would be a dividend of A$0.64cps ($0.91cps with franking credits).  This would be a decline of 70% but would leave the business (and therefore shareholders) well positioned to benefit in coming years. 

At A$0.64cps dividend BHP at its current price (~$20) is trading on a 3.2% dividend yield (or 4.6% gross). For global investors this yield would be in keeping with other large global blue chip companies and therefore means the current market price is “ok”. 

For Australians, however, it looks low (a BHP price of $10-15ps would not surprise us in the short term). It is for this reason that we will remain patient to see if we can build our position in BHP at better prices, and when they are running the business more sensibly. 

Conclusion - Need to be discriminate, patient and long term focused

Whilst it’s never clear exactly where we are on the commodity cycle clock, it is likely that in general we are getting towards the darkest days for the majority of commodities (with exceptions). 

Given the significant run up in supply and cheap credit, we don’t expect to see a significant recovery for many years, at least for most things (we see more scope in some areas than others – like oil and copper, rather than coal and iron ore for instance).

We will pursue opportunities to buy sensible, long term assets at good prices, when they are good prices. However, at this stage there are not many that meet either criteria.  To all those that invest in this space we say “proceed, but with real caution”.

-       Dennison Hambling