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Is investing in resources stocks worth the heartache?

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Is investing in resources stocks worth the heartache?

If you’re an investor in resources companies, you know it’s a bumpy, rollercoaster ride, with periods of glee interspersed with periods of gloom. But is all that volatility worth it? Or are investors better off in the long term investing in the broader market? We did some research, and the results are worth reading.

This year, we’ve seen a significant recovery in the performance of resource companies relative to the rest of the market.

In the year to date, the ASX 300 Resources Accumulation index has returned just under 40% while the broader market has returned 5.3%. This unwinds the underperformance of the Resources index from 2015. If we look at the annual performance of the Resources Accumulation index relative to the broader market, we can see greater volatility in the returns of the mining stocks.

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The chart shows that the cumulative return path for the broader market has been smoother than that of the resources index. Additionally, the resources index has generated a negative return for the calendar year 13 times over the last 37 years. This compares to 10 times for the broader market.

One of the inherent difficulties in investing in resources companies is that controllables of the business tend to be a far less significant driver of investment performance. Movements in global commodity prices play a major role in driving share prices, as has been demonstrated by the recovery in a range of commodity prices during 2016 and the recovery in mining company share prices.

To test the significance of key commodity prices in driving the share price of mining stocks, we performed a statistical analysis of the monthly returns for both BHP and Rio Tinto since the start of 2008. This showed that just under 50% of the total shareholder return in the month was explained by a combination of the movement in key USD spot commodity prices for each company (iron ore and oil for BHP and iron ore and aluminium for RIO), and the accumulation return of the broader market.

What this says is that investors in these diversified miners have largely received exposure to the movements in the broader market, with additional volatility being provided by the movement in these key commodity prices.

An interesting point is that the statistic correlation fell significantly if the change in commodity prices from previous periods was used. This implies that the movements in commodity prices are quickly factored into the share prices of BHP and RIO.

Therefore, to generate sustainable returns above those of the market, an investor needs to be able to forecast future global commodity price movements better than the market on a consistent basis. While there can be periods of time in which an investor might perceive themselves to have a competitive advantage in predicting commodity price movements, it is difficult to maintain a competitive advantage for long period of time. As such, this is more akin to speculation than investing.

While this leverage to movements in commodity prices can see resources companies perform better than the broader market at times, the limited barriers to entry to the market inevitably leads to increased supply and a retracement in the longer term. After all, this is what the price system in a market based economy is designed to achieve.

Stuart is the Portfolio Manager of The Montgomery [Private] Fund. Stuart joined Montgomery in 2015 after spending 19 years in research roles with JP Morgan in Australia and in New York. Stuart was appointed Executive Director at JP Morgan in 2005 and for 8 years was Deputy Head of Research. Prior to this he worked as an analyst in the Australian Equities team at Bankers Trust Asset Management for 3 years. Stuart is a CFA® charterholder.

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This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564) and may contain general financial advice that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking advice from a financial advisor if necessary.

9 Comments

  1. Thanks for your article. I hope you don’t mind if I state an alternate view. On your statement (quote), “Therefore, to generate sustainable returns above those of the market, an investor needs to be able to forecast future global commodity price movements better than the market on a consistent basis”, all I had to do was know when to buy resources stocks. The key is to buy a stock when the company puts all the bad news out and shows that it has cleared the deck financially of all the bad news. BHP did this. I entered BHP at $18 and it is now $25 just a few months later. I also bought Fortescue at $1.80 when it was clear that Iron Ore prices had bottomed and that BHP had restructured its debt repayment commitments. I sold the stock last week for $6.11, I made a fortune.

    On your statement that “it is difficult to maintain a competitive advantage for long period of time”, I agree, but to make money on the stock market, it’s all about knowing when to buy and you do that when a company puts all the bad financial results out and shows that it has dealt with the bad news. I did the same with Qantas. When CEO Alan Joyce clearly outlined how Qantas had dealt financially with the difficult times and explained that Qantas had turned the corner the stock was priced at $1.31 and I hopped on board. It ran to $4 and is still over $3.

    It’s all about knowing how to understand company announcements and buying before the media noise commences. There is so much media noise at present about whether resources are a good thing. I just laugh because those commentators who now commenting positively about resources have missed the boat by 6 to 12 months.

    Cheers,
    Paul

      • There were a number of indications. The price of iron ore had big rises from December last year into January and February, a clear change of direction, trend and sentiment. Of course, I had no proof that the price had bottomed but as a technical analyst the indications were that sentiment had changed. Stocks such as FMG took time to react. FMG was still low in February and lagging behind the rise in commodity price. Buying at $1.80 is far more attractive proposition than when it was up around $5 to $6 and with a medium timeframe in mind I could handle some further downside for a while. You also need to make investment decisions in context with the structure of your overall portfolio. I wanted to increase my weighting in the materials sector so that influenced me to be in FMG as well. Also, I saw nothing from Andrew Forrest (Fortescue CEO) to indicate he was worried. I tend to take note of very smart businessmen. That’s why I also bought Qantas when everyone else wouldn’t go near it. Alan Joyce knows what he is doing, he’s proven his credentials, as has Twiggy Forrest.

    • Hi Paul, that goes precisely to my point. Your comment that you bought BHP at $18 when iron ore prices had clearly bottomed is easy to see in hindsight. Iron ore was around US$40/t in Dec 2015. At that time BHP was trading at around A$18 per share. Since then iron ore prices have increased to almost US$80/t. This is the primary driver of the recovery in the BHP share price. However, there were plenty of people that called the bottom of the iron ore price (often for what seemed like rational reasons at the time given the cost per tonne of the marginal producer) all the way down from US$170/t in 2011. With the share price of BHP falling from A$35-40 per share at that time, you could easily have lost significant amounts of money ‘picking the bottom’.

      In regards to QAN, again the driver there was primarily the benefit provided to margins from falling oil prices. The share price started to recover in mid 2014 as the Brent oil price started to slump from a mid 2014 peak of US$100/barrel to around US$35/barrel in January this year. Capacity takes time to respond in the airline industry given the lag in building new aircraft. As a result, airline yields remained high for a sustained period of time in the face of falling fuel costs, boosting QAN’s earnings. However, inevitably, elevated margins brings on capacity growth which in turn drives down yields and margins as a result of the low barriers to entry and Government subsidisation of the international carrier market. This has resulted in in pressure on QAN’s margins more recently. Consequently, I would suggest that the returns you have enjoyed in QAN has had less to do with an management decisions and more to do with the temporary benefit of lower oil prices on margins.

      • See above for my reply about the bottom of iron ore prices.

        Concerning Qantas, fuel price movements have benefited the company but I think it was more to do with the restructuring of the company and the massive cost savings to be generated from that (and which have since occurred). Also, the new alliances such as that with Emirates, upcoming plans to restructure its fleet to better focus on new destinations, especially in the Asian region. These are the issues that set the platform for Qantas to have a prosperous future with earnings growth prospects and that is what drives the market price up.

      • You can can put your faith in ‘it’s different this time’, I prefer to put my faith in the likelihood that a poor industry structure will inevitably mean revert.

  2. I vehemently disagree re: “limited barriers to entry”, certainly with respect to mining.

    It is a hugely capital intensive business (which stops a lot of people in the first instance and itself, is a barrier), you have to be lucky and smart enough to find something (a lot of people go broke, never to be seen again in the mining game) and then, be able to extract it at a good price for sale at an even better one (which again, is a barrier against high cost / low quality mines).

    Having a world class, long-life mining asset, you can effectively tie the market up and be a price-maker; this is nothing new amongst commodity businesses and in fact, goes for any business (even bad ones) with a monopoly !

    If it was easy, everyone would be doing it.

    • Hi Chris, you have actually highlighted my point. The best companies are able to reinvest capital generated from their businesses at a high rate of return. A mining company that gets ‘lucky’ with a world class deposit is unlikely to win the lottery again with the money it reinvests from the profits generated by its low cost operation. Invariably the company will reinvest profits at the wrong time of the cycle (ie when commodity prices are high) due to that being when they generate the most cash, only to destroy shareholder value.

      In terms of your comment regarding monopoly miners having pricing power, I don’t know of any that you could argue have this. A low cost mine is likely to deliver earnings throughout the life of that mine given the commodity price is generally determined by the marginal cost base of the highest cost producers, but this does not equate to pricing power. Nor does it allow the low cost miner to reinvest capital at the rate of return generated on its original mine.

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