FYI, attached below Merrill Lynch's view on commodities equities. Note the extra bullishness on bulks which I share...
What commodity prices are imputed in share prices?
When a sector is “bombed out” and appears cheap, it is a good sanity check to illustrate which commodity prices are imputed into share prices in order to minimise risks for those investors looking to buy.
We can make a very good approximation of the commodity prices that are being imputed into share prices for stocks by assuming the market is rational, and making the current share prices = the NPV of an equity. We then back-calculate which commodity prices are needed (flat in nominal terms until 2015 when they are indexed at 2.5%pa) to make the NPV = the share price.
Commodity prices in share prices are WELL < spot
Using yesterday's closing equity share prices, the imputed commodity pricesfactored into share prices for diversifieds assuming a flat A$/U$ 0.87 forever are:
Iron ore fines U$65/t (63% Fe) or U102.2c/ Fe unit
(-28% vs JFY08 contract settlement for Au producers of U$90/t)
Coking coal U$200/t
(-34% vs U$305/t JFY08 settlement or -45% vs XTA av settlement U$362/t)
Thermal coal U$80/t
(-50% vs Newcastle FOB spot & -41% vs av JFY08 contract price U$135/t)
Aluminium U$1.15/lb (-7% vs spot U$1.24/lb)
Copper U$2.3/lb (-32% vs spot U$3.38/lb)
Nickel U$7.50/lb (-13% vs spot $8.66/lb)
Oil $65/bbl (-43% vs spot U$115/bbl)
All other assumptions as per ML base case forecasts
So, what do you do?
The above analysis indicates that the current share prices in this over-sold sector are imputing commodity prices WELL BELOW spot levels and well below most sell-side (or buy-side) forecasts. This gives us comfort that the risks of buying quality stocks at this seasonally low point is underpinned by commodity prices, particularly bulks, that are much higher than ML or the market has factored in.
There will likely be more volatility in share prices in the short term; however, investors should be using pull-backs as an opportunity to get set as the bottom
appears very near and valuations are compelling. If you can buy stocks at a 20% discount to NPV, 5-8x PER and under-geared balance sheets with strong returns
and margins, then bite the bullet and do it.
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