Why are we recommending resource shares?

Geoff Blount, CEO of Cannon Asset Managers, looks at a dripping roast.

Cannon Asset Managers recently issued a note indicating that an industrial large cap bubble is developing on the JSE and, like all bubbles, this one has created an investment opportunity elsewhere in the market. And the most unloved sector at the moment? The unpopular resources sector.

Given the highly cyclical nature of resources stocks, Cannon prefers to use the Cyclically-Adjusted PE (CAPE) ratio for assessing them. It not only removes forecasting risk of getting the currency and commodity cycle right, but also removes the near-term problems of the trailing 1-year PE for resources, which often misreads for commodity stocks. The resource CAPE, by using a more stable through-the-cycle “DNA” earnings number, means that price (P) of the CAPE becomes the principle driver of the valuation tool. In other words, this measure is confirming whether the current price is high or low relative to the CAE (cyclically-adjusted earnings).

We have looked at the CAPE ratios for the resource sector since 1997 and compared this to the ensuing 3-year average annual return from the sector. There is a striking negative correlation between the two. In other words, when the resources CAPE ratio is high, the index has subsequently experienced three years of mediocre – even negative – returns. When the resources CAPE ratio has been low, this has been followed by substantial growth. The analysis of CAPE ratios relative to subsequent returns demonstrates that one of the primary drivers of investment returns is the price paid for an investment, no matter how rosy, or gloomy its prospects look. In other words, don’t let the emotions of the market override whether or not an asset is worth owning or not, look at the price you are paying.

Graph 1 below plots the CAPE ratio (in black, right axis) against the subsequent 3-year annualised returns (green, left axis): the inverse relationship is clearly apparent. The notably low level of the resources CAPE ratio at present would signal a healthy return can be anticipated over the next three years.

Chart 1: Resource CAPE ratios vs Subsequent 3 Year Annualised Returns

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Not yet convinced? The following two graphs clearly reveal two bubbles that we have witnessed in the past and suggest that the large cap industrial stocks are being set up to disappoint over the coming three years.

Graph 2 highlights the build-up and dramatic bursting of the financial bubble in the late 1990s – an accident just waiting to happen. Not only that, the hangover lasted for far longer than three years.

Graph 2: Financial CAPE ratios vs Subsequent 3 Year Annualised returns

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Graph 3 highlights our current concerns, with the CAPE ratio for large cap industrials heading towards record territory. This is a trend that we think can only end in tears. These shares should be avoided until their CAPE ratios return to more realistic levels around 16 times, or lower. Examples of overvalued large cap industrial stocks being swept up in this fervour include SAB, Shoprite, Richemont, Naspers, Woolworths and Aspen.

Graph 3: Large Cap Industrial CAPE ratios vs Subsequent 3 Year Annualised returns

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Emotion often ties investors up. Whenever CAPE ratios go low, investors find very good reasons to avoid that sector. Right now, it is easy to find reasons to own large cap industrials, and even easier to find reasons not to own commodity stocks, as was the case in the late 1990s, 2003 and late 2008 when resource stocks were attractively valued. At each point, investors behaved as though it was the end of the world for commodity stocks:

• In the late 1990s, it was the “end of commodities” as the knowledge economy was the future and this, coupled with the Asian crisis, hurt prices. Investors seem to have forgotten that most SA miners were struggling to make money at that point, and there were wage pacts (cuts) between labour and the mining houses to solve the problems the industry faced;
• In 2003, after 9/11, the world was going into economic lockdown as the war on terror took hold;
• In 2008 it was the global financial crisis and the “end of the world”;
• And in 2013, reasons not to own commodity stocks abound, namely the global slowdown and domestic issues, such as costs escalations, strikes, electricity supply constraints and government policy uncertainty.

However, in hindsight, we see that each of these points has provided a buying opportunity as valuations came under pressure. This time should prove to be no different.

Investors in the large cap industrial stocks appear to find every reason why you want to own these stocks, while ignoring their stratospheric valuations. When the bubble bursts, and it will, they will be sorely disappointed.