Below a view from commodities fund Blackrock (afraid the charts...

Below a view from commodities fund Blackrock (afraid the charts are not attached)

INCOME REAL ESTATE LIQUIDITY ALTERNATIVES BLACKROCK SOLUTIONS
100 days of hell
The background
It was only a few months ago now that we, as investors in the
natural resources sector, were confident of yet another year of
strong returns. At the highs in May 2008, mining shares had
posted gains of 22.6% YTD (in US$ terms) even after hitting a
major speed bump in February.
Demand was strong from China, the world’s largest commodity
consumer, recording GDP growth of 10.4% for the first half of the
year. Elsewhere in the world, India and Russia were booming, oil
prices were moving to new highs and construction activity from
Dubai to Mumbai was forging ahead.
On the other side of the equation, mining companies were
struggling to produce sufficient supply to match demand due to
the headwinds of declining grade, natural disruptions and
strikes. Hungry governments in resource-rich nations were also
trying to squeeze extra taxes out of the sector so they could
benefit from high commodity prices.
In addition to the challenges of production, mining companies
were also contending with rampant cost inflation. High energy
and steel prices were forcing costs higher. Labour was in short
supply, creating stiff competition for experienced mining
engineers and geologists, and backlogs for new equipment were
at record levels.
Despite these pressures, mining companies were reporting
record levels of profitability and with balance sheets groaning
under the weight of such huge cashflows, dividend increases and
share buy-backs were as common as swallows in summer.
M&A was rampant as escalating capital costs and low
stockmarket valuations made buying assets rather than building
them a better way to grow. Late in 2007, the world’s largest
mining company BHP Billiton made a hostile bid for its nearest
rival, Rio Tinto, at a significant premium to the market price. This
move was then sent off course by an overnight purchase of over
10% of Rio Tinto by a Chinese led consortium. This prompted
BHP Billiton to raise its bid further, leaving Rio Tinto
shareholders with a pro-forma 44% of the combined company
should the deal go ahead. At the same time, Vale was in the
midst of discussions to buy Xstrata and numerous smaller deals
were being consummated.
Against this extremely strong background, credit problems in the
US had been uncovered in August last year, but it looked as
though these would be confined to the financial sector and were
manageable issues for the global “real” economy.
Indeed, during August and September 2007, what – at the time –
was thought to be the midst of the credit turmoil, Rio Tinto
managed to negotiate a massive U$42bn acquisition facility to
complete the purchase of Alcan, the Canada-based aluminium
producer. Rio had won this bid against stiff competition from
Alcoa and other leading groups.
The combination of all of these events translated into some
stunning returns for the Fund. During 2007, the Fund was up
59.6% for the year and to the end of June 2008 it had added a
further 12.0% gain.
The perfect storm
From June this year the situation changed for the worse and for
the next couple of months things started to decline in what
looked to be a normal slow period associated with the annual lull
in metals demand during summer months.
The leading mining companies reported record earnings for the
first half, further M&A was announced with the move by Xstrata
for Lonmin and Sterlite bidding for Asarco. Indeed, come August,
despite some falls in share prices, the picture continued to look
rosy, especially for the bulk commodity producers as they had
locked in 60%-90% price increase for iron ore, over a 100% price
increase for thermal coal and a massive 200% price increase for
coking coal. Given these prices were fixed until April 2009, the
earnings for these companies would be secure even if other
metal prices deteriorated.
However, things were to get very ugly indeed. The magnitude of
the credit crisis started to show itself. Investment banks such as
Lehman Brothers and Merrill Lynch revealed serious financial
failures to the market. Subprime credit issues were blamed and
these then spread with other investment and retail banks
reporting massive losses.
Investors, fearful of bank collapse, rushed out of equities and into
Treasuries and cash. Hedge funds that had been using investment
bank balance sheets to leverage their investment ideas were
suddenly required to unwind their positions as banks called back
capital to reduce pressure on their own balance sheets.
This perfect storm of selling created the mother of all bear
markets where necessary sellers battled with reluctant buyers to
offload investments. This then heightened anxiety in others,
bringing fear-driven sellers to the market and compounding the
downward pressures. The speed at which this happened seems
to have caught all investors off guard, especially those exposed
to the banking and resource sectors.
The sudden change in sentiment in financial markets was like
two massive tectonic plates shifting repeatedly during August
and September and then, finally, breaking apart, causing a
financial earthquake the likes of which we haven’t seen before.
Mining share prices, despite all the positives covered above, were
crushed. As you can see from Chart 1 below, until this year the
largest month-on-month fall in the history of the index had been
-34.9%, but this proved to be a minnow compared with what
happened this year.

Monthly moves of -16.6% to 27 July, followed by another 22.1%%
to 27 September and finally a further 53.9% to the low of the
market (so far) on 27 October left the index down 74.6% from the
May high to the recent October low. This unprecedented fall in
valuations has destroyed US$1.1 trillion of market cap and nearly
four years of positive returns from the Fund.
A bubble?
One of the things that journalists have been all too quick to write
is that the bubble in mining shares has burst. However, we as
investors wish that we had been in a bubble market as it would
have resulted in returns far greater than those we had managed
to generate. Mining shares never reached premium ratings to
the rest of the stockmarket. Nor did they trade on bubble-like
multiples. They were enjoying huge profitability and had difficulty
in redeploying the cash generated by their real assets. Chart 2
below shows the forward price to earnings ratio of Rio Tinto and
at no stage did it reach levels seen either in its own past or
during the tech bubble.
Where do we stand today?
The question investors are asking us today is: how are we doing
in the aftermath of the share price bloodbath? In addition, they
want to know what we have been doing in the Fund during this
period and, most importantly, are we still in business to benefit
from the current situation.
Well, the good news is that unlike many of our competitors
(some of whom you will have read about in the media) we are still
in business and despite the horrific last few months, the portfolio
is as “high quality” as ever.
We have actively allowed the strongest companies to become even
bigger holdings in the Fund and, as such, the likes of BHP Billiton,
Vale and Rio Tinto make up over 30% of the portfolio. These
companies own most of the best mining assets in the world and,
combined with outstanding management teams and profitable
operations, are well placed to see out the economic hurricane. On
the same theme, the portfolio only has around 1% invested in
exploration companies, around 4% in companies with market caps
less than U$500m and over 92% invested in companies paying
dividends. In fact, the running dividend yield on the portfolio is the
highest it has been since the Fund’s inception back in 1997.
We have also been taking advantage of the share price collapses
caused by the necessary sellers. Almost every market expert is
telling people how low valuations are using P/E and cashflow
numbers. We have chosen to ignore this as it is likely that it will
take some months for true visibility of the “E” to be clear, so we
instead have chosen other measures.
For example, many mining companies are now trading below half
the replacement cost of their assets and a recent report from the
independent analysts at Liberum points out that even some of
the majors are trading at 0.8x replacement cost, something we
have never seen before. Many of the companies would love to be
able to take of advantage of this, but – given the freeze in credit
markets – they are unable to do so. This is a major competitive
advantage of our Fund versus the companies.
Super cycle – is it over?
Well, demand isn’t going away for ever. In China, GDP in 3Q08
was 9%, the government has already started to stimulate the
economy with three interest rate cuts, the removal of demand
restraining taxes and huge investment plans.
In the US, there has been a change of leadership and new
administrations nearly always announce large spending plans. This
time, however, it is likely to be the biggest one ever. Commodity
supply growth is being reined in by the huge cuts to spending on
announced projects and the lack of finance available for future
projects. For the companies, the cost inflation they were facing
earlier in the year has also abated. The cost of diesel and steel has
fallen sharply. Employees are now more worried about retaining
their jobs rather than striking for higher wages. Also for those
companies with assets located in Brazil, Australia, South Africa etc
the collapse in the local exchange rate will insulate profit margins
from the fall in US$ commodity prices. Even the dreaded “resource
nationalism” is now becoming less of a concern.
In summary, then, we feel that the interest rate cuts from the Fed,
the ECB, the BOJ and the Bank of England, although positive for the
medium term, haven’t come soon enough to head off a recession in
the western World over the short term. Against this, the drivers of
the super cycle remain intact, but with all the distractions of the
credit crisis to deal with investors are not interested. This has left
the equities trading like short-term derivatives on commodity
prices when, in fact, they should reflect the fact that commodities
are not a luxury goods item; they are depleting, have to be replaced
and are needed for real industrial consumption uses. This will not
escape the attention of mining company managements and when
credit markets thaw there will surely be a feeding frenzy of M&A.
So, with just over 100 days of hell behind us, we feel like there is
reason for optimism and clearly we are not alone. At the time of
writing, the major mining shares are up – in some cases by over
50% – from their recent lows and on large volumes. Some
investors, including us, are bottom-fishing and just maybe these
real assets might regain some of their recent glory.
The key message of this newsletter is that mining shares are
“long-dated” assets behaving like “short-dated” assets. This
situation will not last forever and investors should take
advantage of it while they can.