From offensive to defensive: Defensive resources, gold

It was one month ago today that the world was dumping resource stocks because they were “risky”. Today they are buying them because they are “defensive”.
One word you never see associated with resource stocks is “defensive”. However, here we are and the investing world believes resources stocks have the highest degree of defensive characteristics under the set of macroeconomic circumstances we are now operating under.

Resources are correctly being seen as a defensive hedge against inflation and a defensive hedge against the structural decline of the US Dollar. They are also seen as a defensive hedge against rising borrowing costs and interest servicing obligations because the sector carries so little debt.

As we repeatedly wrote last month the market made the absolutely wrong decision on what was true “risk”. They made the incorrect assumption that “resources = risk”. Even BHP tried to get the point across saying at their results presentation that “they were surprised their shares fell more than leveraged financials on sub-prime concerns”. Nobody listened to them so they bought back 30m shares in the U.K from shorters.

In pure risk adjusted terms the lowest real risk sector was (and is) resources and amazingly the market believed the right decision was to crunch P/E’s even further in resources.

Since the Fed exercised the “Bernanke put” that entire P/E and then some has been put back into the resource sector, led by the gold, iron ore, uranium and oil sectors.

I think this has been exactly the right response. There should be no doubt that the Fed drew an economic growth targeting line in the sand with last week’s decision. The market believes the Fed has moved away from inflation targeting to growth targeting and the medium-term ramification will be inflationary pressures surprising on the upside. The market has come to the right conclusion.

The gold price moving to 28 year highs is telling you two clear things. 1. That the USD is in structural decline and 2. That inflationary pressures are going to surprise on the upside.

When you look at the trading response of both hard and soft commodities to the Fed’s decision you can see the clear and present risk of inflationary pressure.

While our friends in the credit markets continue to point out that they think equity market investors have “lost their minds” and are ignoring risk, we think the credit market commentators aren’t seeing that the equity market is bidding up “inflation hedges”. Inflation hedges make up a high percentage of the ASX20 and that is where the money has been flowing. It has been a narrowing rally led by genuine “inflation hedges” (i.e. BHP outperforming the index by 100% off the lows) and that’s what the credit market commentators aren’t comprehending.

The equity market is aware of risk but unlike the credit markets we are looking forward and discounting future risk. The market is clearly positioning itself for a higher inflation environment. In that context it means it is positioning itself for an interest rate response from the RBA in the form of higher cash rates which will see the A$ through 90usc.

The market is rotating aggressively to the lowly geared and those with pricing power. It is rotating to hard assets away from paper assets and I think this absolutely the right strategy.

Get all the pricing power you can

I cannot reinforce enough how important genuine pricing power will be as a factor determining outperformance over the next few years. Pricing power is a factor we are always long in our strategy, but we think we are entering a period where the ability to raise final prices ahead of input prices is absolutely crucial.

If you don’t possess pricing power you are going to underperform. If you are not operating in a highly consolidated industry you are going to struggle to raise final prices. Input costs are going up for everyone. Think about it; oil, interest servicing, wages, food, metals, steel, EVERYTHING. In fact, I can’t think of a single input price that is falling.

For those companies who don’t posses final pricing power this is going to be an unpleasant period of margin squeeze. The last thing I would want to be holding over the next few years is a highly geared industrial company with rising input prices and no real final pricing power.

While industrials continue to command roughly a 50% P/E premium to resources there are VERY few industrial companies who can truly grow earnings and margins in a scenario of EVERY input price rising. The question you have to ask yourself is whether we see some long-overdue P/E re-allocation from industrials to resources? I think the answer is absolutely yes.

We have talked about this scenario for some time. We banged on and on and on about a P/E re-rating for resources. Call us a broken record but it’s finally starting. Who would have though it would be the Fed’s response to a possible US recession that would be the trigger this long-overdue P/E re-allocation to resources?

The next few years are all about hard assets and transparency. I also think it’s about low gearing.

LPT’s; welcome to a bear market

The arrival of private equity in Australia saw Australian industrial companies up their average gearing ratios. You can argue this was completely at the wrong time in both the asset price and interest rate cycle. Clearly, the highest risk sector remains the listed property trust sector.

LPT’s led the market, particularly the highly geared and highly acquisitive. They were re-rated and re-rated and re-rated. The P/E’s exploded on the upside as they became priced as “fund managers”. They paid out dividends higher than their earnings streams and it was all about cheap finance, management fees, and revaluations. Quite frankly, there was a lot of financial engineering and the market fell for this unsustainable low interest rate model.

It wasn’t that long ago we wrote a note which re-named the sector “listed property time bombs” which was like a red rag to all the LPT bulls. I stand by the view that the highest real risk sector in the Australian equity market is the LPT sector. These used to be stocks for Grandma’s; that is no longer the case.

The market has started de-rating LPT’s but I think this is only the beginning. While many are 20% off their recent highs they remain over-priced and risky. I would also challenge the carrying valuations of those with US assets. This concept that LPT’s are fund managers and deserve a funds management multiple is just not correct. Yes, some deserve a premium to others because they do have more reliable earnings streams from forms of funds management, but at the end of the day these LPT’s should trade near their NTA’s. There was a classic bubble in LPT’s and we are seeing the infancy of it unwinding. The sector raised a truckload of equity at the top and all the momentum funds are still long. The LPT index peaked in March and this will be a multi-year bear market for LPTs.

There was and is absolutely nothing defensive about the way these geared property trusts are priced. These are leveraged paper assets in a world that seeks hard assets. Sure, the assets are property backed, but the NTA’s are nowhere near the share prices in most cases. You are paying a big premium to the underlying value of the hard property asset while funding costs are rising aggressively. We would strongly prefer to be paying no premium to NTA to buy hard assets.

BHP (blue) vs. Centro (red)

I look at the Australian resource sector and I see the complete opposite to the LPT sector. Look at the chart above of BHP vs. Centro (CNP). The market has gone for hard assets and low financial leverage in the wake of sub-prime. After 5 years of basically tracking each other BHP and CNP have completely diverged in performance. This is what the credit guys don’t understand. There is an equity market reaction to the credit market disruption and this is an example of it.

I see hard assets trading at a discount to their 'real NTA”. Sure, some sceptics will tell me “the major brokers have resource NTA’s below the current share prices’. Yes they do but that’s because they continue to use last century’s commodity prices in their forecasts. Whack in an $80 oil price, a $730oz gold price, a $3.50 copper price, 30% higher coal prices and 50% iron ore prices and then tell me what your “NTA” is?

I will guarantee you that using commodity prices anywhere near spot prices will see resource sector NTA’s significantly above the share prices we see today. The market, while acknowledging the commodity super-cycle, remains scared of forecasting it.

It is amazing, this is the biggest event of our investing generation yet brokers believe LPT’s should trade as fund managers yet commodity prices will revert to last century’s mean. That remains a huge error.

You must hedge yourself against inflation. We are clearly entering a sustained period of inflationary pressure. It is not a matter of if; it’s a matter of when.

Resources = inflation hedge

We see the Australian resource sector as the first place to find inflation hedging. There is low gearing, high interest cover, consensus earnings upgrades, dividend growth, transparency, and pricing power. The iron ore sector is about to demonstrate true pricing power. Industrial companies with give their left and right legs to possess the pricing power the Australian iron ore sector has.

As usual the broking community is belated in upgrading iron ore price forecasts for JFY 08. None of them have really put their balls on the line and forecast freight rate equalisation or any outcome near current iron ore spot price. Of course, our broker competitors love sitting on a fence and then making after the event upgrades. This is how they have approached the entire commodity cycle to date. We remain of the view that a “stunning” outcome ( 50%) will be achieved and this will lead to analysts re-assessing the pricing power the Australian resource sector has.

I can’t stress enough how you want to be positioned in PRICE MAKERS not PRICE TAKERS from this point onwards.

In resources and industrials it is all about being long PRICE MAKERS and short PRICE TAKERS.

It’s also all about being long LOWLY GEARED companies and short HIGHLY GEARED companies. Anyway you cut it the cost of credit is going up. The long-term ramification of the sub-prime meltdown is a re-pricing of credit spreads to reflect the true risk of default. Again, resources win on this measure as well. The sector remains the sector with the highest interest cover and lowest net debt to equity ratios.

Adjusting the model portfolio

On Wednesday August 29 we published the concentrated model portfolio below. Since that day this 20 stock model portfolio has delivered a 7.8% return versus 5.3% from the ASX100. In brackets is the ASX 100 index weight for each stock pick. The returns are absolute and don’t include dividends paid.

In response to our view that we want to be extremely overweight inflation hedges and those with pricing power we have made some adjustments to the model portfolio.

We are selling our QAN holding at a small profit and re-allocating its 3% portfolio weighting 1% each to FMG, OXR, and CTX. FMG is now 5% of the portfolio, OXR 4%, and CTX 4%.

Anyhow, this is just a way of SCE testing whether we add value via recommendations and portfolio strategy. Cleary this is the case. The first few weeks have shown you that a 20 stock portfolio can outperform the index sharply, but you really have to get BHP right or you are basically stuffed. It is that simple. Get the BHP weighting wrong and you are playing a massive game of catch up.

This whole BHP index domination situation reminds me of News Corporations total dominance of the index in the late 1990’s early 2000’s.

These are such interesting times. I do believe the most defensive sector in the market in risk adjusted terms is the resource sector. Without any doubt resources are the best inflation hedge. Interestingly, it’s also the most offensive in terms of leverage to global growth. However, resources remain the cheapest sector and the sector cum the largest consensus earnings upgrades. You are witnessing the infancy of a complete leadership change in Australian equities. As we keep writing this will be a multi-decade event yet who is positioned for it? The “perfect storm” continues for resources driven by the new economic world order.

As Madonna sang “we are living in a raw materials world”.

I urge you to click on the archive at the top of this note and re-read some of our notes from the last month. They are they most accurate we have ever written and I hope you followed them.