The ‘Jekyll and Hyde’ nature of resource shares
The JSE All Share index is dominated by resource counters. The country’s top ten companies (by market capitalisation) include five commodity plays: BHP Billion (R548.834bn), Anglo American (R393.478bn), Sasol (R184.558bn), Anglo Platinum (R166.007bn) and
At a recent Sanlam Private Investments (SPI) Investment Outlook presentation, held in Johannesburg on 8 March 2010, Alwyn van der Merwe tackled some of the tough questions facing asset managers. Should fund managers be aggressive buyers of resource shares through 2010? And if yes, then should total portfolio exposure to resource shares exceed their 45% weighting in the All Share index?
Rollercoaster performance linked to commodity prices
Resources outperformed the market in the five years beginning 2004 with a total compound return of 44% per annum. Over the period the resources index gained 260%, beating financial and industrial shares by a significant margin. Investors bought the market aggressively on the assumption the bullish trend in commodity prices would remain intact indefinitely. Nobody expected the global economic meltdown that followed. Between May 2008 and the market bottom in March 2009 local resource shares shed 60% of their market capitalisation.
Resource share prices have recovered markedly since then. Investors were lured back by expectations of an 82% surge in FY2010 earnings from the sector. In their haste to catch the next commodity wave they’re ignoring some serious risks. Forget commodity price trends for a moment and focus instead on the operating environment. Van der Merwe took a detailed look at Anglo Platinum (going back 14 years) to better understand the challenges facing local platinum miners. His first observation is the production costs associated with a single ounce of Platinum Group Metals (PGMs) are in a steady upward trend. Mining costs jumped from R2 000/ounce in 1996 to R7 000/ounce in 2009. Over the same period smelting and refining costs climbed from R2 500/ounce to R13 000/ounce. Despite small reductions in overall costs in 2009, the gap between per ounce platinum revenue and operating costs is narrowing. Once capital expenditure is introduced to the mix the available profit is decimated.
This pressure is evident in 2009 mining sector results. Kumba Iron Ore was among the best performers. Earnings at this iron ore producer declined a mere 5% in 2009. Shareholders at Anglo American (-35%), Harmony Gold (-48%), Northam Platinum (-78%) and Impala Platinum (-85%) had nothing to celebrate, while steel producer ArcelorMittal converted 2008 earnings of 2120c/share into a 104c/share loss! Earnings may surge 82% this year, but the majority of mining companies will report worse numbers in 2010 than two years previously.
Commodity prices and currencies must play ball
The economist data metals index shows that commodity prices are close to their 2008 highs. This fact does little to motivate an overweight resources position. “We get excited when commodity prices are low,” said Van der Merwe. Right now there is limited scope for further increases. To make matters worse the rand should remain strong for as long as US interest rates are on hold. The fragile state of the US economy means the Federal Reserve may be forced to pin interest rates for the next to years...
After considering the various risks, including the upward pressure on costs and limited upside for commodity prices, SPI is underweight resources. The resource weighting in their portfolio is around 30%.
What sectors should investors consider? Van der Merwe cautioned that the current economic uncertainty would make it difficult for DIY investors. SPI is watching global economic developments carefully, but doesn’t believe any of the threats identified thus far will be ‘game changers’. Equities will still provide real returns, and any dips in overall market levels will present further buying opportunities.
Tobacco ring-fenced by ‘barrier to entry’
Many of the country’s Top 40 shares are priced too aggressively right now. One of the shares worth considering is British American Tobacco (BAT), a long-term SPI favourite. The company has survived the storm of public opinion around tobacco related illnesses and continues to produce real returns for its shareholders year after year. The company’s strength is perfectly illustrated by the 18.8% per annum total return achieved by locally listed Remgro Limited, which earns a big slice of revenue from BAT dividends. Tobacco shares have provided consistent growth over the past three decades in strong contrast to the ‘boom and bust’ developments in information technology. There are a number of reasons for this.
The industry is protected from competition by high barriers to entry and is able to pass annual price increases to its customers in the shadow of regulatory hikes in so-called ‘sin’ taxes. There is also a strong chance the counter will be added to the JSE Top 40 index later this year. If this happens – BAT represents approximately 12% of domestic market capitalisation –there could be a number of forced buyers on the market. Van der Merwe says BAT offers real value at R250 per share. The counter should grow intrinsic value over time and pays dividends close to 5% (in British sterling) each year.
Editor’s thoughts: There is a growing global trend toward socially responsible investing. Portfolios with mandates to follow such strategies will ignore firms that generate income from so-called ‘sin’ activities, including brewing and cigarette manufacturing. Have any of your clients refused to invest in companies like BAT or SAB miller? Add your comments below, or send them to [email protected]
