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Mineral rich

Sean Kenzie offers some perspective on investment opportunities amid all the doom and gloom.

It is hardly an understatement to say that investors the world over are confused over how to allocate their investment capital. Investors in equities, bonds, commodities, oil, gold, private equity and hedge funds are all struggling to make money as price volatility abounds. At the same time we’ve just had the dramatic intervention by the US Federal Reserve and Treasury to bail out US mortgage institutions Freddie Mac and Fannie Mae and provide an unequivocal signal that the US is prepared to do whatever it takes to protect the financial system and induce banks to lend.

Is the equity bear market over? Are commodities another burst bubble? Will banks return to their highs any time soon? Before we can address these questions, we need to dig back into the story of what’s been going on over the past year to get some perspective.

In the run up to July 13 this year, the investment landscape was very clear. Shares of mining companies, energy companies and agricultural companies were by far the best performing sectors. These gains were primarily fuelled by rising commodity prices and in part by the perception that the emerging economies of Brazil, India, China and Russia would still grow at a level that would not materially hamper world GDP growth. These companies were generating huge amounts of free cashflow and have enormous pricing power. The investment case was further strengthened by valuations that were by no means overstretched, meaning that these companies found it cheaper to buy their peers rather than invest in new supply capacity creating further upward pressure on prices.

Meanwhile crude oil was touching $147, corn and wheat were near record nominal highs, creating a global food crisis, and the US dollar was inexorably weakening against most global currencies, indeed touching a high of $1.60 versus the euro.

At the same time, shares of global banks continued to be marked lower as the European banking sector traded 41% below its October 2007 highs. Banks perceived as riskier traded far lower: Lehman Brothers was down 73% from its highs and the three main Irish banks were down 62.6% on average. The Sovereign Wealth Funds

(SWFs) who had stepped in to rescue some of the major banks with equity and debt purchases were deeply underwater and most likely loath to make further commitments.

Equity markets were trading at three year lows into July 13 and squarely focused on the continued series of asset write downs on the balance sheets of banks as a result of the subprime mortgages fallout, as well as the inflationary pressures generated by record food and energy prices. Financial markets were in a very bad place.

Then in stepped the US Treasury, using its own (taxpayers’) balance sheet to guarantee the survival of Fannie Mae and Freddie Mac. Equity holders were left to hold the losses; debt holders (including $947bn held by foreign central banks) receive the federal government’s full backing. Despite the scandal of moral hazard, and protracted deception by these institutions’ management, there was no alternative to the bailout, as systemic risk in the US financial system was too high. This action over the weekend of July 13 was the major catalyst in the commodity market correction. These actions sparked the rally in the US dollar, the 20% correction in the price of gold and the huge unwinding of leveraged positions in all the commodity investment themes that had worked up to that point. Fears were abound that China would significantly slow after the Olympics. The US administration had to get the banks share prices up high enough so they would attract new equity.

Actions earlier this month merely formalised the arrangement. Once investors began to believe that certain big banks would not be allowed to fail, they bought banks and sold commodities. The current trend is unsustainable and returns offered by banking shares are at best flat over the next two to three years; in direct contrast to the commodities sector.

Investors should bear in mind the secular shift in sector capitalisation weightings in the stock market, which has not been seen since the early 1980s when financial stocks made up 6% of the S&P500 compared to 22% at the peak in 2007. Conversely, energy stocks made up 27% of the S&P500 in 1980; fell to 6% in 2003; have grown to 14.8% today and will probably grow back towards the 1980s weighting. Banking stocks as a group, conversely, are seemingly on their way to a single digit weighting.

For let’s be clear here – we’ve had the biggest credit bubble in history between

2001 and 2007: a seven-year period where Bank of Ireland was able to increase its earnings per share by 130%. This was engendered by central bankers’ response to the fallout of the 1995–2000 TMT (technology, media and telecoms) bubble where interest rates were held at historically low levels to stave off recession at all costs. In essence, the very instrument central bankers used to try to avoid the world having to deal with the fallout of one asset bubble sowed the seeds of the next.

This process of keeping growth going involved Irish, UK, US and Spanish households piling up huge debts on the back of easy credit from banks, which created the conditions for the housing bubble. Indeed, the process was circular, in that the further property prices rose, the more people borrowed against property to maintain spending. As Chuck Prince (the deposed CEO of Citigroup) said, “When the music plays you have to dance”. But now the music has stopped and the world is deleveraging.

The focus of attention had now turned to earnings growth and bad debts – the other shoe dropping if you will. First, we get the credit crunch, then the macro, ground level implications of much slower lending growth; increased bad debts; impairments and likely dividends cuts. Essentially, if the banks don’t want to lend and consumers don’t want to borrow, where does the earnings growth come from in the medium term?

And so, the prospect of Irish banks returning to their 2007 highs is years away in our view. History shows that this is what happens when bubbles burst. Take the TMT crash, for example, when Intel lost 80% of its value (similar to Bank of Ireland) from peak to trough. It has subsequently enjoyed spectacular rallies since the 2002 trough, but its share price has remained unchanged in 10 years.

Research from Merrill Lynch looks at previous recessions and in particular how much banking profits fall in such periods as well as how long it takes to work through. Big commercial banks say their profits declined 38%-54% in the recessions of 1990-94 and 2000-03 respectively.

Profitability took 1.5-2 years to bottom and four years to return to previous peak levels.

All this suggests that profits, following the above model, may not bottom until late 2009 or the first half of 2010. It would also imply that profits may not return to peak levels on average until 2011. The current banking crisis is far more entrenched in the global financial system than that of the early 1990s, with the savings and loans crises that contributed to the malaise.

Meanwhile emerging markets as a whole are predicted to spend $21 trillion on infrastructure projects over the next decade. Indeed, mining companies themselves consistently say that demand growth for commodities is unlikely to be that severely impacted in the medium term by what is going on in western markets. Volatility is likely to continue, commodity prices are likely to remain strong and this may prove to be a record year for earnings in the mining sector. With this in mind and mining equities currently trading at 10 year lows on a price to earnings basis, the sector appears to offer compelling value for investors. At the same time, despite a $40+ slide in the spot price of crude oil, oil for delivery in 2013-16 trades at or above $112. This is the current long-term expectation for the price of oil. The era of cheap and easy oil supply is over and the world economy will have to make a slow and painful adjustment to alternative fuels as part of the solution.

Meanwhile resource nationalism, where countries such as Russia seek to develop supplies according to their own agenda and under their own control, hampers the free supply of oil. Indeed it is quite a risk for Europe that Russia control 30% of our oil supply and 50% of the natural gas supply. Additionally, most of the easy places to find oil have dried up. Energy analyst, Charles Maxwell of Weeden & Co points out the classic example “that in 1985, the North Sea produced 2½ million barrels a day from nine fields, compared with about 1.7 million barrels today from nearly 100 fields. We are running desperately on a treadmill on which it is very difficult to stay up, because they are not finding as many new fields as old fields are being depleted.”

Certainly slowing economic growth reduces demand for oil in the short-term, but price is eventually the only factor that will slow down the use of oil and force the painful move to alternative fuels or changes in current political thinking and policy in the US around heavy oil, tar sands and indeed exploration offshore. This will create significant opportunity for investors in drilling companies and Canadian oil sands. Changes in this direction are afoot. Indeed Senator John McCain has abandoned his long time support for a ban on offshore drilling. He said on June 8: “I believe it is time for the federal government to lift these restrictions and to put our own reserves to use as a matter of fairness to the American people, and a matter of duty for our government, we must deal with the here and now, and assure affordable fuel for America by increasing domestic production." Both he and Barack Obama have recently changed their position on this issue.

The essential point is that an investment in companies that are part of the supply solution at current depressed level are likely to be the outstanding investment choice over the next two to three years. These companies trade at similar levels to the banking sector, yet with double digit earnings growth, a potential catalyst of a change in energy policy.

 

Sean Kenzie is associate director and head of equities at Custom House Capital

This article first appeared in the quarterly Business & Finance publication, Finance Quarterly Q3 '08