Mean reversion

Mean reversion

A lot has been written about the woes of the resources sector recently with a similar amount of energy spent trying to work out when is the right time to expect ‘mean reversion’. A simple theory that although sounds complex, really just suggests that prices and returns eventually move back towards the mean or average as time periods are extended. Given the resource sector has been a material underperformer of late, the theory suggests you should reallocate a portion of your portfolio to such businesses in the expectation (or hope) that if such an event occurs, recent underperformance will lead to outperformance.

Sounds good in theory.

Long-term followers however would know all too well that we have had very little exposure to resources and resource services companies and looking forward, our positioning is unlikely to change materially even if such an event was a probable one. Why? Well, even while resource-like businesses still do represent a fair share of the Australian Stock Exchange, both by number and market capitalisation, the reason why we prefer to avoid investments in this area is pretty simple: we seek to own high quality businesses with bright prospects. A key feature of a quality business is an ability to control 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, gold, iron ore, oil, gas] from, it’s all the same stuff. Ultimately the buyer just wants the raw input to turn into other products as cheaply as possible. That’s not attractive from a business economic perspective.

To put our view into another perspective, let’s say today you are offered the opportunity to buy a 10 stock portfolio of the largest, most well-known resource-like businesses on the Australian Stock Exchange for $203 billion. These businesses in 2017 are expected to generate $11 billion in after-tax earnings and those quick with numbers will observe that this implies a lofty but not excessive price to earnings ratio of 18.41 times future earnings ‘estimates.’

For that sort of multiple, you would expect to see a decent amount of historical growth as evidence that your portfolio of 10 business will be able to grow in the future. This is important given one would need evidence that your portfolio has a real opportunity to grow into its above markets average pricing / valuation. The average business on the ASX currently carries a multiple of circa 15 times forward earnings to put this into relative perspective.

Let’s say that you now go back in time to the end of 2012 where you discover that this same group of resource-like businesses were then forecast to make $32.8 billion after-tax earnings. After you reconcile that, with the $11 billion forecast today, you would notice that in between these two figures there is a clear trend of lower forecast profits (which continues to fall to this day), not higher. And given its a well established trend, its highly likely that this will continue. On that basis, you’d be a bit mad to take up the opportunity wouldn’t you?

Armed with this knowledge, unless you had a very good reason to expect the fortunes of this group of businesses to turn around, and soon, a multiple in excess of 18 times earnings could not be justified. You, like us, would simply move onto the next opportunity.

No, i’m not making this up! That’s exactly the situation facing investors who hold some of the top 10 resource companies on the ASX including the likes of BHP and Rio Tinto. All we have done is gone back in time and looked at the trend in the 2 Year Forward Consensus Analyst Net Profit After Tax estimates (red line), measured on a monthly basis. On top, we have graphed this against their respective tmarket capitalisations (grey bars) and as shown below, it’s not a pretty picture:

Our conclusion on this is pretty simple. Whilst others may wish to try and pick the bottom of the cycle, our view today is the same as it was back in 2012/2013. At a minimum, until we begin to witness an expectation that earnings for the sector are looking like they will recover and again grow, at 18.41 times the risk to our clients capital of further losses is just too high in the face of persistent negative earnings revisions (for this group of 10) given continued poor outlooks for commodity prices. There are simply better opportunities elsewhere.

Given their highly cyclical nature, earnings for resource focused 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 been highly volatile. When you consider this fact, there is a clear explanation as to why share prices for many resource companies are today the same or lower than they were 10 years ago.

Indeed perhaps this is the only mean reversion that was due to present itself after a decade long-run of out-performance pre 2012.

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