Growing up in Perth, escaping the mining industry was almost impossible.
Every second person seemed to work in mining, provide services to mining companies, or had a family member whose fortunes rose and fell with the iron ore price.
After moving away, I assumed I'd left most of that behind. Yet, here I am writing about BHP.
Perhaps that's no surprise. Whether owned directly, through super or via a fund, Australia's largest listed company sits in countless portfolios. In one way or another, a large portion of capital is tied to the fortunes of the resources sector.
Shares hit a record $68 in late August, after results showed underlying profit jumping 30%, as well as a 65% jump in dividends. All figures that were unlikely to draw many shareholder complaints. But is there a need to be cautious?
Most companies are assessed based on their ability to grow revenue, take market share or improve margins. Mining is different. A company can have world-class assets, low production costs and excellent operations, yet still see profits collapse if commodity prices move against it.
In industry jargon, miners are "price takers". When commodity prices are strong, earnings often surge. When prices weaken, profits can fall just as quickly.
Yet when earnings jump, our instinct is often to extrapolate this. History suggests we’re at our most optimistic near cyclical peaks and most pessimistic near cyclical troughs.
Some perspective
My colleague Lochlan Halloway recently performed an analysis to determine what expectations are already embedded in BHP’s share price. At present, it trades around 4.5 times book value, which is a lofty multiple for a cyclical business.
Using a standard valuation framework*, this suggests the company needs to generate a return on equity of around 30% over the long run. Not necessarily every year, but on average through the cycle. In other words, the market is expecting a very high level of profitability for a long time.
To put it in perspective, BHP generated a return on equity of 27% in its most recent financial year and this was a period that was reasonably favourable for commodity markets.
History suggests that paying such valuations can still be rewarding, but only under exceptional circumstances. The clearest example is during the China-led resources boom between 2003 and 2012, when industrialisation created a once-in-a-generation environment for miners.
Even investors who paid seemingly high valuations were rewarded as the boom proved larger and longer than most anticipated. Of course, the challenge is that periods like these are rare.
The role of copper
Copper has become increasingly important to BHP's future. Much of the investment case rests on themes like AI, electrification and renewables. All roads seemingly lead to higher copper demand. If these structural drivers translate into a meaningful and sustainable increase in consumption, current prices may be justified.
However, I find that compelling narratives often become embedded in prices long before they become embedded in reality. As prices move higher, producers have greater incentive to expand existing production, as well as explore alternatives.
The elephant in the room
For all the discussion about AI and electrification, it is easy to forget that the biggest force in commodity markets over the past two decades has been China. The country accounts for over half of global refined copper demand, yet demand seems to be slowing amid concerns about the economy.
While investors focus on future sources of demand, a key question is whether they are paying enough attention to the world's largest existing source.
Indeed, it is industry consensus that the world will require substantially more copper than it does today, however, whether it requires enough to meet expectations is the difficult part.
It's often said that investing is the art of distinguishing between what is already known and what is not yet reflected in prices. In his book The Most Important Thing (2011), Howard Marks describes this as:
“First-level thinking says, ‘It’s a good company; let’s buy the stock.’ Second-level thinking says, ‘It’s a good company, but everyone thinks it’s a great company, and it’s not. So, the stock’s overrated and overpriced; let’s sell.’"
Concluding thoughts
If it isn’t already obvious by now, I am not a geologist, mining engineer or commodities forecaster.
Like most investors, I have no unique ability to predict where prices will be the next decade. Commodity markets are influenced by several complex factors like economic growth, advancement in technology, supply disruptions and so on. It is not my intention to make a grand call on whether copper is headed materially higher or lower from here.
However, it is worth delving into how other investors are thinking about such businesses. Investing is less about predicting the future than it is about understanding the expectations already embedded.
*Assume a standard set of assumptions for a perpetuity model: a 9% cost of equity, long-run growth of about 3%, and a business that distributes most of what it earns.
Simonelle Mody
Also in this week's edition...
Testamentary trusts are often considered a vehicle for the wealthy. Estate lawyer Abbey John, explains how even the typical Australian family could save in taxes.
The superannuation debate has been reignited and Kaye Fallick is back to discuss whether the system needs another look.
House prices are slowly sliding, but Michael Collins argues that job losses amid growing economic risk, could turn the correction into a crash.
Susan Bell presents new research from Challenger that reveals the greatest retirement risk in a generation.
Do you qualify as 'rich'? Mark LaMonica attempts to evaluate what financial success really looks like.
The market is always stirring with new narratives. Diana Mousina from AMP shares five risks to watch out for.
Amongst the hard-to-miss headlines about the weakness in global bonds, Christine Benz asks whether some investors are missing the point.
Curated by Simonelle Mody and Leisa Bell
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