It was ever thus
A month relatively devoid of European news was a welcome respite. However, the fact that the lack of news was a result of Europeans not being at work rather than any proposed solutions is somewhat ironic, as the refusal to change rigid workplace laws and amend retirement ages is at the heart of the region’s current and future financial destitution. Without an ineffectual European meeting to take centre stage, news flow was dominated by more fundamental news items, the most topical of which was undoubtedly the alarming fall in the iron ore price and the resultant question marks over the state of the Chinese economy. Buoyed by large doses of recency bias, many had become convinced that cost support for iron ore was at US$120-130, thus preventing price falls below these levels. Closing below US$90, those cost support levels have been well and truly breached and have sowed some seeds of doubt in the previously unassailable belief in never ending Chinese growth. As vocal sceptics on the sustainability of Chinese policies, we cannot say that we are surprised, although we can acknowledge that we had no idea price falls were coming this month nor profess any insight into whether prices will rebound or fall further in the short term. Identifying unsustainable levels of demand, earnings and pricing is far easier than ascertaining when a turning point may be nigh, which is why sustainability will always take precedence over timing in our investment decisions. The implications of falling iron ore prices were felt quickly. Higher cost producers such as Atlas Iron (-21.8%), Mount Gibson Iron (-23.6%) and Gindalbie Metals (-18.0%) were amongst the obvious victims, whilst Fortescue Metals (-13.3%) and Rio Tinto (-6.2%) were progressively less impacted. Second order impacts on mining services businesses were similarly severe. Boart Longyear (-38.4%), Ausdrill (-16.2%), NRW Holdings (-14.5%), Monadelphous, (-7.8%) and Leighton Holdings (-6.6%) delivered results ranging from weak to solid, however, announcements on delays to BHP’s Olympic Dam project and a tendency towards far more cautious commentary on future demand meant that the direction of price moves was uniform.
Whilst the above reactions to sudden and unexpected changes in price are unsurprising, they provide insights into the behavioural patterns which from our observations seem to constantly befall both investors and companies. Whether stemming from overconfidence, over optimism or simply the tendency to extrapolate, when it comes to pro cyclicality, the majority of politicians, investors and company management teams are recidivists. The resource boom came as a result of an extended period in the doldrums which saw minimal capacity addition and weak pricing. The inability to forecast the boom in Chinese demand and the supply demand imbalance which followed, saw prices skyrocket. As they skyrocketed, booming demand was forecast forever and capacity addition became rife. This capacity addition will be the factor that extinguishes the boom. It was ever thus.
From the perspective of shareholders the more pernicious outcomes are often driven by the combination of this pro cyclicality with financial leverage. Devoted adherents to financial theory are looking to constantly optimise their theoretical cost of capital, meaning that cyclical stocks which generate large amounts of cash at peak cycle conditions seek methods through which to increase gearing to avoid accusations of running a lazy balance sheet. In reality, the deeply cyclical nature of these businesses dictates that they should have lazy balance sheets at peak cycle conditions as this position will invariably be rectified through natural forces, ensuring that they are over leveraged at trough cycle. Businesses such as Alumina, Fairfax Media, Bluescope Steel and Paperlinx are examples of those currently experiencing the dark side of cyclicality. Lessons on financial leverage are provided to investors on a regular basis. As I say to my kids, the challenge is to pay attention in class (an exhortation which, like most investors, they duly ignore). Let’s highlight a couple of recent examples. Santos, Origin Energy and Woodside Petroleum are all engaged in the construction of LNG plants which involve the deployment of massive amounts of capital expenditure. The early stages of these projects were characterised by typical wild enthusiasm. All were going to generate exceptional IRR’s (Internal rates of return – a term most often used in projects where returns in the early years are exceedingly mediocre and all proponents will be retired by the time the forecast ‘rivers of gold’ fail to materialise). Those imbued with a degree of common sense would suggest that the high risk construction phase of the project which involved exceedingly large amounts of capital expenditure and no corresponding cash flows would best be financed with a large amount of equity which could then later be substituted for debt once the project was up and running and generating cash. But no, the more popular methodology these days is to use project finance from day one, as banks struggling for credit growth and replete with healthy levels of artificially cheap central bank funding are only too keen to proffer large amounts of debt funding. This ensures that shareholders retain massive leverage to the changing NPV of the project, as debt holders obviously take no downside until equity is exhausted. Unsurprisingly again, the peak in optimism for the returns from these projects was just prior to actually starting. Since then, the trends have been firmly in one direction, not up. As a result, shareholders have worn every dollar of downside from capex blowouts, insufficient gas and higher operating costs and the stocks have performed accordingly. Our message, leveraging into over optimism is almost always a bad idea, and over optimism is unfortunately a lot more prevalent than undue pessimism. Similar thinking pervades our views on all sectors which we perceive to be earning unsustainably high returns. Our long held caution on stocks such as Fortescue Metals stems predominantly from capital structure. Moving from an extended period of exceptionally high prices towards a more normal environment is a bad time to have bucket loads of debt. Having performed almost identically to the largely ungeared and lower cost Rio Tinto since the start of the year we feel investors are missing something.
If you get the feeling that we believe it’s not an optimal time to take on loads of debt you would be correct. In general, the greatest gains from financial leverage will come when it is generally shunned and interest rates are high. This is when the greatest scope for falling rates and increasing leverage can provide the greatest impetus for asset prices. That would not be now.
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