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.
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.