The road less travelled: a sceptic’s view of the commodities boom c

The case for the believers

The case for the resource believers is reinforced con­stantly through
the bullish sentiment from the media, stockbrokers and resource
company executives.
Competition for superla­tives remains intense as "stronger for longer"
is superseded by "100-year boom", "stronger forever" and "it's
different this time". The gist of the 'believers' arguments is
similar, but the central tenet is a demand-led argument stemming from
a number of reinforc­ing factors:

> Chinese economic growth. After an extended period of extremely strong gross domestic product (GDP) growth (it has not fallen below 7 per cent since 1991), growth momentum has increased the confidence among most of the financial community and the gener­al public, that growth will continue unabated. The primary reasons for expect­ing continued growth appear to be extrapolation in addition to the scale of ongoing capital investment and the 'once in a lifetime' industrialisation of the world's largest population.

> Decoupling. As the slowdown in western economies, particularly the United States, has chal­lenged the traditional com­modity price response (ie, declines), the term 'decou­pling' has been coined.

> India. With the large population base of China being a major driver behind the story, the potential for India's similarly large pop­ulation to act as further stimulus for the demand story is logical.
On the supply side, sim­ilarly emotive arguments add further fuel for
the believers:

> Inability to secure new supply. While arguments on 'peak oil' have been around for decades (and yet to be realised), the inability to add supply quickly in many commodities due to infra­structure and labour supply bottlenecks has fuelled con­cerns over the ability to add supply in the longer term.
The ability of these argu­ments to elicit an enthusiastic reaction
among a large number of investors is obvi­ous. The opposing case for
sceptics is perhaps more complex.

The case for the sceptics

Calling into question the structural elements of the commodities boom
may be somewhat heretical at pres­ent. However, with the con­fidence
that 'burning at the stake, has been abandoned as punishment I'll try
and make the case for why I believe the boom to be cycli­cal rather
than structural, and prices of resource stocks, in most cases, to be
unsustainably high.
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Separating the impact of price and volume

In many commodities, the lack of investment in mining and associated
infra­structure over time has been a significant factor in the current
supply demand imbalance. In some cases this imbalance has been
exacerbated by marginally greater than expected growth in demand.
However, price is the important factor in relation to the current
imbalance. Exceptional growth in prof­it, cash flow and return on
capital, are almost always driven by price, as this requires no
further invest­ment. The complication in forecasting relates to the
ability to determine the price at which additional supply will be
encouraged, the price at which demand will be destroyed, and how long
prices will take to return to equilibrium.
Commodity producers have been enjoying that most gratifying phase of
profitability, in which sup­ply has been increasingly squeezed in a
broad range of commodities.

Impact of GDP growth

'Growth' is a particularly alluring term for both investors and
companies although it tends to be poor­ly understood. 'Growth' is an
input to the 'value' of any business, rather than an attribute that
should be sought out regardless of value.
By way of example, a recent article in the UK's Financial Times, made
ref­erence to an investor who proposed an argument that the Chinese
stock market may be reasonable value at a PE ratio of 100, or an
earnings yield of 1 per cent, on the basis that when GDP growth of 10
per cent was added to this return, a total figure of 11 per cent was
more than acceptable, par­ticularly relative to the returns available
for alter­native Chinese investments.
The assertion that the earnings yield of a business can be added to
the GDP growth of the country to arrive at a total return expec­tation
is ludicrous. The GDP growth a country will accrue to both existing
and new competitors has little to do with the returns an investor will
earn, as it gives no insight into how much addi­tional capital will be
required to generate this growth.

Corporate activity – justification or capitulation?

The flood of Chinese capital targeting Aus­tralian mining company
stakes has further fuelled the current frenzy and some say a
justification for current valuations.
Fortescue is a good example. While it's been an amazing feat to
develop the Fortescue business in such a compressed time frame, if one
focuses sole­ly on the investment merit at current prices, it's a case
of overvaluation.
Developing the mine and infrastructure has seen cap­ital investment of
around $3 billion, however in total enterprise value (debt + equi­ty)
the stock market now values this business at more than $30 billion.
Investors buying the stock today expecting a return of say 10 per cent
will need pre-inter­est and tax earnings of around $3 billion in
perpe­tuity to deliver this return.
This assumption dictates that the original capital employed would earn
a return on capital employed of 100 per cent in perpetu­ity. Historic
evidence and fundamental laws of eco­nomics suggest the proba­bility
of this outcome is par­ticularly low.

Factors exacerbating commodity prices

Supply and demand imbalances alone are nor­mally insufficient to plant
the seeds for a 'bubble'.
However, the equation is being aided by a number of coincidental
developments in the financial industry.
The litany of repack­aged and restructured assets designed to lure
investors with the prom­ise of attractive or better yet, uncorrelated
returns, is never ending.
Even in the aftermath of sub-prime, the financial industry is more
concerned with identifying the next hot product than embark­ing on the
process of reform. Commodities trad­ing is a case in point.
From my perspective, there is absolutely no doubt that the entry of
long-only investment capital is impact­ing price in almost all
com­modity and energy markets, the only question is how much.
The influence of investors such as hedge funds, supposedly providing
'effi­ciency capital' to markets, is less clear.
However, it is likely that these participants will at the very least,
amplify volatility in each direction.
These futures contracts will need to be 'rolled' at regular intervals,
and require an opposing investor to take the other side of the
transaction. The only natural sellers of com­modities are producers
who obviously have a natural limit to their desire to sell forward
future production.
If, as is most often the case, trades are executed through investment
banks and there is no natural seller, investment banks or other
intermediaries will need to hedge the other side of the transaction by
eventually accumulating physical prod­uct. Every paper commodity
investment must eventually be backed by product.
The other contentious issue in explaining the inex­orable rise in
commodity prices is the contribution of overly easy monetary policy to
the equation.
Recent years have seen an almost unprecedented peri­od of coincident
growth in global economies, fuelled significantly by extremely strong
credit growth.
This booming period of credit growth has facilitat­ed a boom in both
con­sumption and investment.
The balance between consumption and invest­ment varies by economy.
Economies such as China have been powered almost solely by an
explosion in fixed investment, the US has consumed, while economies
such as Aus­tralia have been some­where in between.
The masters of extrapo­lation are assuming Chinese fixed investment
will con­tinue unabated. In my view, economics will eventually apply
to this investment. Erecting buildings, steel mills, aluminium
smelters and endless other infra­structure projects is only sensible
to the extent that end demand ensures these projects earn a sensible
return on capital.

Conclusion

These arguments are not intended to represent the rantings of an
aggrieved investor who happens to be on the wrong side of a pool of
investments subject to powerful momentum, although I will be the first
to confess to frustration.
They are intended to lend some weight to the case for investors to
consider the possibility that the com­modities boom may be cyclical,
and that assets in the area may currently be substantially overvalued.
The forces of momentum are powerful and the impact on human behaviour
equal­ly powerful, however, it is these factors that should ensure
fund managers apply even more rigorous analy­sis to the allocation of
cap­ital to companies in times such as these, rather than succumbing
to the path of least resistance.
I, for one, don't subscribe to the lemming theory of commodity prices.

Martin Conlon is the head of Australian equities at Schroders.
(This article is a synopsis taken from the paper titled 'Hymns for the
non-believer' by Martin Conlon dated June 2008.)