Commodities & FMG - My latest article

Having taught Econometrics to Macroeconomic students who try to forecast commodity markets, I have had an interest in Commodities for some time.

So with that interest, I thought I would share some personal views on where Commodities could be heading.
Since 1970 history shows us Commodity markets often move in cycles that have similar draw down periods; over 4 phases - from Shock, Correction, Expansion to Capitulation.

In the last 50 years, commodity markets experienced 3 price cycles (as shown in Table below). The last cycle, known as "Commodity Super-Cycle" attracted broad attention, lasted for almost 10 years from 1999 to the summer of 2008. The growth of the Chinese economy, which sparked additional commodity demand, catapulted nominal prices to levels never seen before. When comparing the previous boom phases in 1970-1974 (+318%) or 1986-1990 (+193%), the commodity super-cycle trended over a long period but with a sub-average price increase of +220%.

It is important to note the first initial phase of a commodity bull market is characterized by a multi-year price increase caused by a temporarily supply and demand mismatch, which is followed by a price correction in phase 2. During the expansion phase supply is growing, but commodity prices are accelerating as well (phase 3), whereas phase 4 is a culmination point of supply and demand mismatch which is followed by severe adjustments.

What we have seen recently, however is that the Chinese economy is experiencing a slowing down in growth due to its transformation process. The growth in the economy slowed down to a staggering 6.8%, clearly lower than the 14.9% in the booming years and lower than the average growth of the past 15 years of 9.4%. However, the negative sentiment towards China in my view is exaggerated. President Xi Jinping targets a minimum growth of 6.5% until 2020 and has embarked on the One Belt One Road, with a required $5 trillion of Infrastructure needs (PwC) as over 800 million Chinese and 1 billion Indians move into the Middle Class. This in my view is why we just ended phase 4 and are about to embark on Cycle 4 and phase 1.



Further supporting this notion, is that when you look at the correlation between the S&P500 and Goldman Sachs Commodity Index, there has never been such a wider divergence in nearly 50 years. Following the notion of mean reversion, we should potentially be seeing attractive investment opportunities.

What supports this even more is that Apple’s market Cap, could buy all 14 Global Gold Producers, not once but 2.5 times. It just shows how Investors have turned away from Commodities, and moved to the FANGS (Facebook, Amazon, NetFlix, Google) – which many are trading on Price/Earnings ratios over 200, when the markets 100-year average is 16. Yet as the great Benjamin Graham says “In the short run, the market is a voting machine but in the long run it is a weighing machine.”

So to see if we are currently voting or weighing, I ran a query on all Stocks in the ASX to see which have the highest Acquirers Multiple, to see where Mining companies sit in the ASX 200. The Acquirers Multiple is a common valuation tool, that assesses the buyout return of a business, by dividing EBIT and Enterprise Value. Enterprise Value is calculated as the market capitalization plus debt, minority interest and preferred shares, minus total cash and cash equivalents.

It was no surprise to see that 5 Mining companies are within the Top 10, of over 2,160 listed companies in ASX. Criteria for search; Market Cap>100m, and Debt/Equity <50%.



One that really stood out for me, was Twiggy Forrest's, Fortescue Metals Group (FMG). To buy FMG outright, with no premium is now worth c$17.4b. Not a bad price, when it has over $131b worth of Iron Ore reserves, and last financial year it delivered underlying EBITDA of $4.7b – a return of 27.0% - even without record commodity prices.
Upon research, FMG has had a strong history of hitting production guidance, and quarter on quarter has shown an ability to deliver lower cash costs. It now has the lowest cash cost in the Industry.

FMG will release its September Quarterly this Thursday. It looks to have banked an additional $1b in cash, given all in costs including Depreciation and CAPEX of $23.5USD and a September Iron Ore price of $71US before an assumed 30% discount. This will increase its total Cash position to an impressive $2.8b.

What is really amazing is that in it will start the Quarter with Debt of only $1.78b and therefore in three more quarters even if 62% FE Iron Ore stays at $60, with the wide discount of 30%, FMG will be close to net debt free – only $58m in debt. An amazing achievement for a company three years ago that had Total Debt of over $12b. Yet no one in the market seems interested in FMG, as the Share price has fallen over 20% in the last two months to $4.92, yet is trading close to NTA.

I forecast FMG EBITDA worst case for FY18 at $4,069m. This would see the highly unlikely 30% discount between what FMG sells for 58% fe and 62% fe continue, Iron Ore prices remaining at c$60USD for 62fe, FMG making no improvement in C1 cost, and it missing production by 5%.  All highly unprobeable scenarios - but best to err of the side of caution. This would still deliver an Acquirers Multiple return of 20.6%, putting in in the top 20 of the ASX. Further with Net Debt then close to zero, the company could look to accreditive acquisitions, commence a Share Buyback, or pay out earnings in the form of Dividends at the upper end of the 50-80% guidance.

This is where things get interesting. Mining companies have always historically never been Dividend plays. Yet if it conservatively pays out the midpoint payout ratio of 65%, with Earnings per Share at the low forecast of 59 cents, the Dividend would be a minimum $0.38 – a 7.63% yield or 8.81% fully franked at current prices. Then the question becomes, will Mining companies like FMG become the new Telstra for SMSF’s?

Of course, I could be wrong but what is apparent from the analysis of the last 50 years, is that a bullish sentiment in commodity markets is not necessarily associated with an increase in economic activity and rising interest rates, but what was shown in the table above is that investors should carefully watch for an acceleration of inflation and the end of the regime of a strong USD.

Omnium Optimi
(Latin-All the best)

Note: these are my own views