A commodity conundrum

Benjamin Graham, author of “The Intelligent Investor” and one of the twentieth century’s investment legends, recommended a number of investment rules to seek out undervalued shares. One of these, still widely used today, is the “Graham-Dodd p/e”. This ratio compares the share price of a company with its average earnings, usually measured over the past 7 or 10 years. The idea is to smooth out volatile swings in annual earnings, thereby arriving at a truer measure of a company’s earnings power. Graham recommended only considering shares on lower than 15x p/e as potential investments. It is by no means a perfect valuation measure, but it is more useful than a p/e ratio based on a single year’s earnings, and it also back tests pretty well.

Once or twice a year I run a screen using the Graham-Dodd p/e on the entire UK stock market to look for potential new ideas. Today, this screen is dominated by the resources companies – integrated oil and mining. Why are these companies screening so cheap? And what determines if they are attractive investments today? The answer to both questions could be summarised in one word: China.

The past ten years has been a golden age for resources companies. Although China has been growing at a rapid rate for over 30 years now, it was not until the turn of the millennium that the economy became large enough in absolute terms to really start having a material impact on global demand for resources. It was also around this time that the components of China’s gross domestic product (GDP) growth began to gradually shift away from exports towards more resource intensive activities such as infrastructure and real estate. The result was a huge boom in demand for resources – copper, iron ore, coal and to a lesser extent oil. The global supply chain was not equipped to deal with this new source of demand. The result was the so-called “commodity supercycle” – rapidly rising prices, and very strong earnings growth for the resources companies.

Today the future path of growth for China is much less clear. It appears that much of the recent GDP growth has been driven by a misallocation of capital towards capital intensive activities that may not earn positive investment returns. The result has been a build-up of debt used to finance this growth, much of which is now increasingly hard to service or repay. Recognising this cannot go on, the new Chinese administration is attempting to rebalance the growth model, such that it is less capital intensive and more consumer driven. History suggests this is a difficult trick to pull off, but whatever happens, it looks likely that Chinese demand for resources will be lower in future than the market previously thought.

China could thus explain why resources companies are screening cheap today. Historic earnings were high because of high and rising Chinese demand. But today there is great uncertainty around the future path of Chinese demand, hence causing the share prices to be low relative to past earnings. Do these low valuations make these companies attractive investments today?

Here I think it is crucially important to distinguish between the oil companies and the mining companies. Although both appear cheap on the Graham-Dodd screen, the former are arguably lower risk because global demand for oil is much less distorted by China than it is for mining companies. China is around 10% of global GDP but consumes over 50% of the world’s iron ore. The equivalent figure for oil is 11%1. To the extent that China is the main risk to future demand for resources, investing in cheap oil companies is considerably less risky than investing in cheap mining companies.

Matthew Tillett

1. Source: IEA and World Steel Association

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Author - Matthew Tillett

Matthew Tillett

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