Coxe talks "dirty"...
Nesbitt Burns Institutional Client Conference Call for August 19, 2005
Don Coxe
Collingwood, Ontario
“The TSE mining stocks: Are these the cheapest commodity stocks?”
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Thank you all for tuning in to the call, which comes to you from Collingwood, Ontario where I’m up here for a Canadian securities traders conference. The chart that we faxed out was of the TSE-capped Metal Mining Index and the question that we raise is “Are these the cheapest commodity stocks?”
So, what I want to talk about is the subject of the current Basic Points which is on its way to you. I signed off on it last night and so it’ll be in some form of distribution today. I want to go through a small part of the analysis in this very lengthy report about why I feel quite strongly that investors should be looking at this group – not on the basis of getting out of the oils, because we’re maintaining our bullish attitude to the oil group and most particularly to the oil sands stocks and to the pure refiners – but, we’ve got to face the fact that the commodity groups can have surges of excitement in which one group will outperform another.
I’m a little bit uncomfortable with the fact that oil is been on the front page for so long now. And I’m also a little bit uncomfortable at some of the Wall Street firms are now finally getting around to raising their oil price forecasts. As all of you know who’ve been following my work over the years, I’m pretty comfortable with the view that Wall Street quarter after quarter after quarter was predicting a drop in oil prices.
And although there’s a few of those out there, I was pleased this morning, the good news of the day was a very prominent Wall Street strategist was quoted on Bloomberg this morning as saying that oil prices are about to fall, but that he didn’t predict oil prices going lower than $40…soon. So, that’s reassuring and you’ll also be reassured here hearing from me that I’m not predicting that copper is going to sell at four dollars a pound soon.
But other firms, notably Goldman, and this morning Merrill Lynch have raised their oil price targets and so that to me is a sign that – particularly for new money investing – that the oil stocks may not be your best choice. But my basic theme of basic materials for this decade and indeed probably for most of the next decade is not likely to change. And frankly, the only thing I see out there that could totally destroy this concept would be a global pandemic and the odds are overwhelmingly against that.
But, it is a risk and that’s one of the reasons that we wrote and distributed the detailed report on that, so that clients can understand the nature of this risk and particularly that it’s not a risk that has effected capital markets since 1918. In 1918 the capital markets were of course, totally preoccupied with the World War.
So, therefore, we really don’t know what would happen, should this Avian Flu migrate away from migratory birds to humans. I mention that only because it’s one of these totally unknowable risks. We call it the unknown unknown. But sophisticated investors like to know what it is that is a very, very remote possibility that the financial community doesn’t discuss at all.
And so the analogy I use is 9/11 and I’m quoting Warren Buffet’s comment that they had built into their reinsurance work, the assumption of an event like this, but they did nothing about it. So his comment was you can’t take credit for a Noah if you don’t build an ark.
Apart from that, which may be a thousand to one risk, the commodity story is still The Big Story. And the reason I’m sort of switching the focus on to the mining stocks now is because they have been seriously underperforming the oil stocks and there’s…we started writing the piece last week, and the theme of the piece is that the industry is going to consolidate because – and we set it out in detail – the industry is not being paid to take risk, it is not being paid to explore and therefore organic growth is going to be almost impossible for the industry in any meaningful sense. Meanwhile demand is growing so substantially.
And I’m going to reiterate the big number out there that you’ve got to think about, which is, so far in this millennium a back of the envelope way of figuring Chinese growth in consumption of the industrial metals, which is copper-nickel-lead-zinc-aluminum, is to use roughly the figure that’s published for Chinese GDP growth. So if China’s growing at nine percent, you can figure that their consumption of these metals will rise by about 26-27%.
Now that doesn’t mean automatically that there’s a huge increase in Chinese imports to exactly that amount because of course the Chinese do produce a lot of these metals on their own, most particularly aluminum and zinc.
But what’s been happening is that at the margin, the Chinese ability to meet their own needs is grossly inadequate in the face of these fabulous increases compounded in demand. And I’ll just remind you that even if you take the most bearish forecasters on China – like some of those highly publicized ones on Wall Street – they’re talking about China’s growth rate falling from the 8 to 9% area, which is its average for the last 25 years, they’re predicting that it’s going to fall to 6%. And therefore they are following that up with saying you’ve got to get out of the metals stocks because that would mean a collapse in metal prices.
Well, um…6% compounded growth from China for the next ten years would mean a compounded growth rate of about 18%. Each year being much, much higher so in fact, two years out the growth in consumption of metals for that year would be at the level that it was last year when China was growing at 9 ½%, because of the third and fourth derivative.
So, having set out the background to it, let me go through some of the topics that we discuss in detail in this report.
We start off with the fact that inventories just…keep…on…falling. In some cases they’re down to hand-to-mouth levels. And remember that although we’ve taken out over 80% of the inventories that were there at the end of 2002, on the London Metal Exchange, the COMEX and the Shanghai Metal Exchange, that we’ve drawn down all those inventories and yet we’ve had price increases for the metals anywhere from 50 to 90%. So it’s open to question…well if we only had that amount of growth in consumption and we’ve had inventories at the level they’re at now, how high would these prices have been?
Now the other thing that we cite, that we’re always delighted when somebody who, in effect, we’ve been challenging for the last few years – namely the smartest person in the mining industry, Chip Goodyear at BHP Billiton – sharply revises his approach to the valuation of metal reserves. Now he did this after he scooped Xstrata in the takeout for WMC. And what he said was “Yes, we still have a short cycle for metals, which we’ve had for decades with the rest of the world, but China and India have entered a supercycle and what that means is just a relentless growth in demand for metals.”
And although I’ve used this argument before, using as my models the growth in consumption in South Korea and Taiwan from 1965 onwards, what he’s using is Japan and Germany. And on the basis of the charts that he’s used in his speeches on that, we’re looking at truly awesome numbers for China in coming years.
The blips along the way as there was for those economies, but we’re talking about something where, if you’re sitting in Chip Goodyear’s seat, where you’ve got to sort of figure out where you’re going to be ten years from now and the ten years from now figure is his, for how long it takes now to open a greenfields mine. A brownfields mine is where you add substantially to what you already have in an area, he estimates at five years.
I’m not saying that all of you out there have five and ten year investing horizons, but if you say that this is what the biggest company is thinking about, then you’re going to be more prone to accept the thesis of this piece, that we’re going to see consolidation going forward in the industry and what we saw this week with Xstrata which lost out on its bid for WMC, coming in with what will only be, I believe, the first parts of acquisition of Falconbridge.
If we take those factors and then we add in some others, one of which is that it’s doubtful that any major industry or certainly any major resource industry has the bad history of pollution and disasters that cost workers lives and of community destruction that the mining industry has had over the last hundred years. Not more recently, but if we take from 1900 through to 1975-80, what we have is a lot of bad history and I set out some of that.
And that is coming back to haunt the mining industry, most notably now in the lawsuit in Indonesia, against Newmont, where the head of their operations in Indonesia is in jail facing a life sentence. The company is, of course, vigorously defending him and itself, but what you gotta realize is that the agitators against this are pretty sophisticated because they can cite so many awful things that have happened in the past.
That means that they can use junk science more effectively. We’re familiar with junk science, of course, in North America because of the trial lawyer’s ability to find a stable of doctors and scientists who will tell you that although you have no symptoms of a disease now, you’re inevitably going to have one in 20 or 25 years and you’re entitled to vast payments now for this.
So, junk science can migrate across the globe just as diseases can migrate across the globe. That’s one of the problems the industry has as a major one about bringing on major new projects.
Now we set out a table in this report, showing the two-tier valuations in the mining industry and this is going to have to change. If you take the value, the market multiple for the big companies, which is BHP Billiton, Rio Tinto and Anglo American they trade at lofty valuations. Not lofty, huge in relation to the MSCI Global Index, but lofty in relation to the rest of the industry.
For example, Rio Tinto trades for only about a billion and a half less – of market cap – than Cameco, Inco, Falconbridge, Teck Cominco, Phelps Dodge and Freeport McMoran combined. Those are all big companies. And of course on a combined basis they’re far bigger, in output and profits than Rio.
So what I’m suggesting, if you’re sitting in Chip Goodyear’s chair or the chairs of the CEOs of the other super-majors of the industry, what you gotta say is “Look, I’m not being paid to take risks.” The twenty-five biggest mining companies in the world last year spent $1.7 billion on exploration. They spent that much some time in the 1990’s. The whole theory of commodity prices in open markets is that rising prices attract vast new production.
Well, even if the industry were doing five billion a year in exploration, using Chip Goodyear’s timetable you wouldn’t see new production for five to ten years. But it’s not even stimulating new exploration. Because these companies look at their multiple, and the other companies down the line are smaller ones that are trading at multiples anywhere from eight to thirteen times earnings and they say “There’s no way stockholders are paying us for exploration.” Because it’s a Catch-22.
Either the exploration yields nothing, or if it yields a big new discovery then what that discovery is going to do is going to hurt earnings for anywhere from five to ten years before it starts to generate net earnings.
And if you’re starting out with a low multiple to begin with, then all you do is put yourself in a position where you’re even more vulnerable to a takeover, because the acquiring company knows the present value of an ore body that may come on ten years from now, but the stock market isn’t prepared to pay you for how much you’re making now, let alone for something off in the distant future. Particularly since there’s still people out there who say “You’ve gotta use prices like sixty-five and seventy cents for copper for the distant future.
So, we have a set of perverse incentives to trying to grow metal output. And therefore big companies can say “We can gobble up smaller companies” - the companies are really big actually, but they’re smaller companies – “because we’ve got a P/E ratio which is many cases double theirs, so we can grow that way.”
This two-tier valuation is, I think, at the core of why it is I think you can assume that the big companies are going to get bigger. And even the extremely well-run mid-size companies - I wouldn’t have thought Freeport McMoran and Inco were mid-sized, but they are compared to the biggies - that they’re in a position that the market refuses to pay them for what they’re doing, for what they’re earning. Now this is real frustration and therefore it means…consolidation to me, seems almost inevitable.
Something else out there. If it weren’t even within the industry, China Minmetals lost out in trying to buy Noranda and buying Falconbridge through Noranda. And right after they lost out, CNOOC lost out on Unocal – that’s the oil industry – but the Chinese are licking their wounds now, but meanwhile, we’ve had the first move up of the Yuan and I believe that’s only the first of what will be a long, long-term adjustment to normalize the Yuan and that the Chinese will assume – given their long-term view – that someday it will be the world reserve currency.
And the Yen is going to rise in value and it will really rise in value after September 11th if, as I hope, Koizumi wins this epochal election which we just discussed in this current Basic Points.
So, you’re going to have another set of buyers out there. Because between Japan and China, you can say they set the prices for the metals, by their demand. And so why should they just watch the prices of these stocks go up when they’re the ones who are creating the value by their own voracious appetites. And so, most sense, that given the stocks are so cheap, to buy them.
So what you’re going to have is a whole set of deep-pocket buyers out there who can see the value that the stock market in its unwisdom refuses to see. Now, I’d like to also point out that the strategy therefore of the big companies in the mining industry is the exact inverse of the strategy of Big Oil in North America. Here’s how it works.
The whole royalty trust boom that we see out there which is really dramatic and having spent this week in Canada, you’d be really amazed at the dimensions of the royalty trust move, it’s based on the fact that Big Oil, back in the 90s during their Triple Waterfall crash were in a position that they needed to raise capital for such big projects as they were still undertaking to try to protect their reserve life index but they didn’t have the capital because they weren’t getting the revenues. And they also had low P/E ratios.
Because of the tax structure and the appetite in the Canadian market for royalty trusts, mature production of oil and gas was valued far higher at a royalty trust than it was when it was held by the companies that had discovered and developed it.
Therefore they spun it off to the Penngrowth’s and the Enerplus’s and the others of this world and got the revenue to take on the big risks, which are offshore where you may spend $160,000 a day drilling and may not find something. And so, therefore, the highest level of risk was being assumed by the big companies and the lowest level of risk was being assumed by the royalty trusts.
In the mining industry, it’s the inverse. Because what we do have is capital for exploration being generated enthusiastically in the London market, Toronto and Australian markets. What you see is companies that have no production whatever, or tiny production, but have got big ideas and are going out and spending money on exploration and development…the market is paying up for that.
So, what we have then is two totally discrete valuations of mining companies. Big companies are valued entirely on current earnings with no allowance for metal price increases or for other ore bodies the companies have they could bring on. And the junior companies are being valued on the basis of hope and hype.
So it makes sense in a funny kind of way then for the Chip Goodyear’s of this world to say, “Well, we won’t spend money on exploration. We’ll let the little companies take the risk and when they’ve found the stuff, we’ll buy ‘em.”
Once you’ve actually proved up the full dimensions of a mine, the classic case with junior companies is that the mining stock decreases in price the first few years they go into production. So we have these two parallel industries out there and because of the way the stock market functions, the longer-term strategies for the industries are inverse to each other.
Now, those are some of the themes we discuss in this current issue of Basic Points and as usual, I’m not making any specific stock recommendations here. But, I’m just asking you to take a look at these stocks again and not to be too carried away by the fact that since they’ve underperformed the oils in your portfolio that they’re disappointments.
I look on this as a perceptual problem.
See, again with the base metals, looking at the US market, at least you have oil analysts on Wall Street because there’s always been market cap to support oil analysts. But, with diversified base metals being 1/10th of 1% of the S&P 500, it doesn’t support a lot of big name analysts. And that is another reason why I think these stocks have not done as well.
Now, of course, they’re covered by analysts out of Toronto, London and Australia and by our own analysts in New York, but what we don’t have is the big Wall Street houses having a commitment to analyzing these mining companies the way they now are grudgingly doing with the oil companies.
So, I think that helps to account for why it is that the overall valuation of the industry is so cheap. But I’ll remind you – and Chip Goodyear backs it up with his numbers – that we’re looking at something like a quadrupling of the middle class of China and India over the next dozen years and that’s very much within the time horizon of a mining company, a big mining company.
And all those homes with indoor plumbing, electricity and basic appliances and where a lot of them are going to own cars…where’s the metal going to come from? Who’s going to find it? Who’s going to take the risks? Who’s going to open the mines?
Mister Goodyear refers to driving around Shanghai and seeing all these new apartment towers going up and the air conditioners in the windows and he says “That makes me feel good because we produce copper and steel.” But unlike the other companies, BHP Billiton also produces oil. So he said what this is is an embedded increase in energy demand.
Now as you know, China last year and this year is adding new electrical generating capacity equal to that of the United Kingdom and of course that’s one of the big reasons for the rising price of copper.
But reading through the work…his slide shows and so forth, I feel more convinced than ever that what we’ve been talking about for the last few years is a valid concept and as it gains validity what you’re going to see is rises in the price/earnings ratios of these stocks.
So I’m just suggesting that you get on board before that happens.
As to other topics, within the oil group of course we’ve had a significant sell-off this week. We’ve had a lot of profit-taking and we did have a pullback in oil prices. I mean, they’ve pulled back all the way to $63-$64. Wow. I mean that’s a real price collapse in oil. The price of some of the oil stocks has fallen by a heck of a lot more than the price of oil.
So it illustrates something else, which is when the overall stock market is not going up and the S&P has been a loser for the last few weeks, then investors who have one area of their portfolio in which they have huge profits…they get nervous. And particularly they get nervous if what they’re seeing is from so many of the big strategists out there, a suggestion that something really bad could happen to this group.
So you better take money off the table now and make up for the fact that you’ve got some of these other stocks that were heavily recommended to you that aren’t doing anything or are going down a little bit and particularly are vulnerable to any perception that these high oil prices are going to produce an economic slowdown.
The people who’ve predicted this in the past have egg on their faces. First of all, they said $35 oil would be a bit of a problem. Then they said $40 oil would be a serious problem. Then they said well $50 oil would certainly produce a slowdown. And they didn’t have room on their spreadsheet for $60 oil let alone $65. But, there’s does come a point at which you’ve got to say that this is going to slow down the global economy.
And I don’t know what that point is, I don’t know if we’ve reached it, I don’t know if there’s some distance from it, but what’s happening is that huge…billions and billions of dollars are being taken out of spending on other parts of the economy and are going off to oil companies, going to OPEC, going to commodity traders…in other words, it’s being taken out of the sort of consumer spending cycle. The US consumers, the estimates are, as you know, something like a third to a half of the consumer spending growth in the US has been financed by borrowing against the inflated values of their houses.
What we could have here is a scenario where the house prices stop going up or, heaven forfend, actually fall in price. Meanwhile, they’re paying a considerable amount of money for gassing up their cars and heating and cooling their homes. At some point what this does is have a deleterious effect. Maybe it won’t happen next year. Maybe it will take another two years. I don’t know. But it’s another reason I think, why you want to, within your commodity group, have some diversification.
Because one of the theories is that China and India will keep on growing even when there’s a slowdown in the OECD countries because, yes, they got high energy costs too and consumers, you’ve seen those line-ups in China in the pictures which are an illustration of what price controls have done over there. China’s preventing the refiners from raising the price of diesel and so that means shortages. And this looks like what happened in the United States in ’73, ’74.
So there’s going to be adjustments, but when you’ve got one group that is heavily followed and another group that isn’t and it may be that in the long-term growth of Asia that there’s a better correlation going forward with base metals than there is with oil. And so, for all those reasons, I think it’s a good idea to diversify within your commodities portfolio. But commodities as a group remain very attractive relative to the rest of the stock market.
That’s it, any questions?
Tom F.: Don, when you talk about consolidation in the mining companies and you look at a company like Inco, how much weight should you put on the fact that the liabilities, environmental liabilities, et cetera that they may have out of operating in a place like Sudbury for basically the last century? How would that factor into consolidation theories in this area of the market?
Don Coxe: Well I mentioned Inco and Falconbridge and their problems in the Sudbury Basin but I also mentioned that they are stand-outs in the industry for how they’ve cleaned up their act in the last thirty-five years, thirty-five, forty years. And they’re way ahead of the rest of the industry in general on that. So, as far as I’m concerned, Inco and Falconbridge have less to worry about than some other companies. And in particular, for some global companies in what they did in the Third World…
Tom F: You mean like Newmont…
Don Coxe: Well, Newmont…I’m not convinced of the validity of this lawsuit against Newmont. As a matter of fact, the evidence is strongly contrary…that this is a bum rap. But what I’m saying is, that when you get a case before a jury or for that matter before a court in Indonesia, the kind of evidence that can be brought in about past disasters and how the long-term effects don’t show up for a long time, this kind of thing may well be a case it’s difficult to win.
And so…in a lot of Third World countries what some of these companies that are long-since bankrupt, what they have done, is hideous. And so what you can do is easily get sideshows of these things and come up with them and say this is just another example of it. And Newmont, which is a classy company, wouldn’t have done anything like that. But sometimes you get into a Doctrine of Collective Guilt and the collective guilt is they say you’re part of the same cabal of capitalist oppressors who have no regard for the environment and you get some, you know, Latte Liberal types who are going to come onto your side and say what a rotten industry this is. So, you know, this is a problem for commodity industries, is that they don’t have very many friends outside their stockholders and consumers.
In the case of the mining industry, the consumers are very remote from the company because you don’t know who made the copper and zinc that go into something you buy. You don’t have a particular affinity for that company. So, I’m just concerned that…look, there’s just been so many awful lawsuits against companies in other industries and, I mean the asbestos industry, the Province of Quebec, after they’d nationalized under the PQ Asbestos Corp, then were horrified to find out that asbestos was being outlawed everywhere.
They financed what was the finest research that’s been done either before or since on this and they showed the distinction between short fiber and long fiber asbestos, that the problems of asbestosis and these other kinds of things were due to short-fiber inhalation which you could easily do. And particularly when you were taking down a wall and doing retrofitting and so forth, that this could go into the environment, but that long-fiber asbestos which is a fabulous thing, the best thing as a fire prevention, that there was no evidence whatever to show of these effects from it.
And despite that, despite the fact that none of this has ever been rebutted, asbestos is now still a multi-billion dollar problem in the US court system. Over four hundred companies have gone bankrupt. Companies that bought other companies twenty years after those companies stopped using anything with asbestos in them, they’d all been forced into bankruptcy. If that can happen in the US court system, then I have to be concerned about what happens globally for the mining industry where the connection is much clearer.
So I happen to think Inco and Falconbridge deserve some kind of medals for what a great job they’ve done. Going back to Sudbury and seeing what it’s like now compared to what it was in the ‘50s…it’s almost a miracle what they’ve accomplished. But, you know, the old thing about the evil that men do lives after them, the good is often interred with their bones. When you’ve got some four hundred dollar an hour lawyer putting together the slides for the juries…who knows?
The Newmont case is a big one. And whether you’re a stockholder of Newmont or not, if Newmont loses this…see under US law, what the US can’t do is protect this individual, this poor guy who’s in jail there. They can’t go to any of the international treaties on this because if he’s convicted of something that is a crime in both Indonesia and in the US, then Indonesian law unquestionably applies. And what he’s charged with, in Indonesia, is a crime also in the United States.
So, it’s a really sad lawsuit, so I don’t want anybody on this call to draw any conclusions that I think that any of these big mining companies with any of the kind of managements that they have today or indeed that they’ve had for decades, are guilty of awful things. But I’m talking history has this way. I mean, there are still people in Scotland – I know of them – who will not let anybody with the name Campbell sleep in their house and that’s because of the fact that the Campbells slaughtered the MacDonalds in Glencoe over three centuries ago. And so…we’re not talking about three centuries here.
Any other questions?
Tom F: Thank you, Don.
Sylvain B.: Hi Don. A little bit off-topic here but I was reading an article on the weekend regarding the potential for oil to trade on…oil contracts to trade on the basis of Euros. So the question is, how many countries might be interested in this and what kind of implications could it have on the US Dollar?
Don Coxe: Obviously it’s a negative for the Dollar, because in terms of the use of Eurodollars globally, and as you know, I’ve said a hundred times on these calls, the Eurodollar pool is the greatest pool of short-term capital in the world, far bigger than US M1 or M2. And oil inventories around the world tend to be financed with Eurodollars.
So, if the Dollar is no longer the unit of trade in oil, what that does is dramatically reduces the demand for Eurodollars and therefore takes away a lot of support for the Dollar itself. But, I find it hard to believe that that will happen and in fact, one of the reasons why the Chinese and the other Asian countries currencies have started appreciating or continue to appreciate is a way of lowering energy prices. So I don’t think there’s a great constituency out there to do that. Thank you.
Thank you all for tuning in, we’ll talk to you next week.
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Don Coxe Profile from the BMO websites:
Donald G. M. Coxe is Chairman and Chief Strategist of Harris Investment Management, and Chairman of Jones Heward Investments. Mr. Coxe has 27 years experience in institutional investing, including a decade as CEO of a Canadian investment counseling firm and six years on Wall Street as a 'sell-side' portfolio strategist advising institutional investors. In addition, Mr. Coxe has experience with pension fund planning, including liability analysis, and tactical asset allocation. His educational background includes an undergraduate degree from the University of Toronto and a law degree from Osgoode Hall Law School. Don joined Harris in September, 1993.
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