Industrials vs. Resources

Industrials vs. Resources

Long-term followers of Montgomery Investment Management would know all too well that we have had very little (we have had some) exposure to resources and energy companies since we began on our investing journey. Looking forward, we are just as unlikely to ever hold anything like benchmark weights to these sectors in our funds and for good reason.

Whilst resource-like businesses do represent a fair share of the Australian Stock exchange both by number and market capitalisation, the logic / reason why we prefer to avoid wholesale investments into this area is pretty simple: we prefer to own high quality businesses with bright prospects that have control over the product(s) they sell and also the prices they charge to their clients.

In our experience, resource-like companies are almost the polar opposite of this. Their prospects are often hard to lock down with any certainty given they are highly cyclical businesses and they cannot control the prices for their production. At all points in the cycle from a buyers perspective, it doesn’t matter where you buy your copper from for example – it’s all the same stuff and they (the buyer) just want the raw input to turn into other products as cheaply as possible. That’s not attractive from a business economic perspective.

This dynamic is perhaps best presented graphically and below you will find two charts whereby we have broken up the ASX 200 into 1) Resource only and 2) Industrial only companies. Further to this, we have graphed the current constituents total market caps (grey area of the chart) and total 1YR forward earnings estimates (red line on the chart) since January 2006 to compare their profiles over time.

As we would expect, given their highly cyclical nature, earnings for resource only companies and thus their market capitalisations (remember in the long-term share prices / business valuations tend to have a high correlation to the earnings power of the business), have done little other than being highly volatile. Indeed, forward estimates today (red line) for this collection of ASX 200 resource and energy companies are effectively the same as they were almost 10 years ago.

Conversely, the second chart graphs the same fundamentals associated with the industrial sector of the ASX 200 (everything else outside of Energy and Materials). As shown clearly, earnings estimates have steadily improved over the years (apart from the GFC) and as such, the market capitalisation for this group of companies is materially higher, about double, what it was at the start providing fertile ground for stock pickers.

Whilst we do appreciate that investor’s can and do make money investing in energy and material companies, we believe that these charts show a simple truth in that investing in commodity based businesses is very volatile (risky from a share price point and emotional point of view) and should only be attempted if you know what you are doing. Even then you’ll have to get your timing right or require deep insight into geology, global economic macroeconomics (demand), global supply growth and finally the businesses prospects. This is something that’s just not within our circle of competence. Theres simply too many moving parts.

Despite the interest they gather daily and the amounts of ‘tips’ these commodity based sectors generate, we often hear of portfolios that have been too exposed to this side of the market and have suffered catastrophic loses which will take years to recoup.

It’s a basic human trait to try and make simple things more complicated, but for us we believe when it comes to your hard earned savings, most investors (including us) will sleep better at night and will ultimately do just fine (from a return perspective) if one never owns another commodity business ever again.

Whilst that may seem to be a big call, particularly when we all live in little-china, for these reasons (which are not exhaustive), we have preferred over the years to avoid the guess work that’s naturally inherent in the resources sector. Instead, we have focused the majority of our effort and energy on the higher level of earnings reliability and predictability that is afforded to those businesses associated with the quality end of the Industrial market.

Shouldn’t you?

Russell Muldoon is the Portfolio Manager of The Montgomery [Private] Fund. To invest with Montgomery, find out more.