"History tells that it's generally NORTH from there."
Just because you can dig it up doesn't mean you should
* Marcus Padley * November 15, 2008
Our sharemarket is littered with resources stocks and because of that we assume we have to hold them. But we don't. Here's why:
Big drivers dominate: Resources differ from industrial companies because, like it or not, their earnings and share prices are driven by commodity prices. Nickel, copper, zinc, aluminium, iron ore, coal, oil and gold are the big drivers yet remain completely beyond our control. They need to be going up. Without that, no manner of faith, research or heroics will help you make money in the stocks.
Bear markets: We have all found out in the last year how much damage a bear market can do. In equities you get one every 10 or 20 years. In resources they can happen any time, and sometimes all the time. Equity markets go up 9.5 per cent a year. Commodity prices don't. Before the recent commodity price boom most of them were in a permanent bear market, and despite the protestations of everyone, appear to be going back there.
Predictability: Predicting commodity prices is a lot harder than predicting the earnings of industrial companies. Professional traders dash themselves on the rocks of the commodity market every day. Do you really think you can do better? If you can't you won't get the stocks right.
Volatility: Because commodity prices are volatile, resource company earnings are volatile. Because of that you cannot believe forecasts and you cannot rely on PEs and Yields. They are changing every day. Everyone who bought BHP on a PE of 5x in June has lost 40 per cent and it's still on a PE of 5x.
Research: Because the earnings are volatile so is the research. There is no point relying on recommendations and target prices from analysts who, should the commodity prices move, simply change them - in some cases by enormous amounts, with impunity it seems, to the mortification of those who relied on their previous assumptions. The valuations and earnings in research are only as good as the assumptions on which they are based, and in most cases, that renders the research guesswork at best and a liability at worst.
Earnings guidance: You might notice that a lot of industrial companies give specific earnings guidance but resources company chiefs don't. They know they don't know what the price of oil, copper, nickel, coal or iron ore is going to do between now and then. It would be reckless to give guidance, so they don't. Resources analysts don't get guidance. There is no guidance. Only assumptions.
Hedging: Hedging or not, commodity prices move share prices, and arguments that they can defy the tide because they are hedging will not change that. You are vulnerable, hedging or no hedging. Just look at Newcrest against the gold price back in the '90s when they hedged everything. In lock step.
Optimism: I used to work with a gold analyst who declared in 1997 that the gold price was going down and all the stocks in his sector were a sell. He was right, the fool. He had come out of industry and was far too honest. He hadn't learnt the key to sharemarket analysis: blind optimism at all times. Anything else renders you and your sector obsolete, as he found out. The point is, there are times (in hindsight) when you should avoid resources because commodity prices are going the wrong way. Bear markets in resources are a lot more common than bear markets overall. At times you should be prepared to hold nothing - they do not warrant portfolio inclusion by their mere existence.
Core to the integrity of portfolio theory is the calculation, use and reliability of "expected returns". In resources there are no reliable expected returns, and beyond big diversified reflections of the global economy like BHP and Rio the rest of them are not "investment grade". They are trading stocks, not portfolio stocks. You cannot set and forget. You have to set and "watch like a hawk". They are unreliable, volatile and risky, with bear markets the norm not the exception. Get them right and occasionally you will make a fortune. Get them wrong and there is no floor.
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