Peak times as China consumes

Beijing is to host the Olympic Games in August 2008. China, however, is already holding a gold medal for the double-digit economic growth it has been enjoying over the past few years. A main beneficiary of this growth has been commodities. China had the fastest growth in the consumption of commodities between 1995 and 2004. China is now second only to the US as a consumer of oil. Its consumption of steel rose by 211 per cent between 1995 and 2004, compared with a global increase of 50 per cent. Over the same period, China’s consumption of aluminium rose 219 per cent against global consumption growth of 44 per cent. Zinc consumption increased 281 per cent compared with global consumption growth of 135 per cent. This demand is reflected in commodity prices. At the start of 2006, the price of nickel was $14,000 (e10,000) a tonne, for example, but it rose to $32,000 at the beginning of 2007 and reached a record $51,800 on 9 May 2007. The price of uranium has risen twelvefold over the past four years. The price of commodities has also been pushed up through a lack of investment. “The supply has not been increased sufficiently to meet greater demand,” says Jonathan Blake, manager of the Baring Global Resources fund. “Investment has taken some time to be made because the management of many companies were not convinced that the commodity cycle would last as long as it has.” Ian Henderson, manager of the JPM Global Natural Resources fund, says: “It is not possible to increase supply overnight. The length of time from finding new sources of commodities to bringing them to market varies, but it can be anywhere from a few years for smaller open-cast mines up to 20 years. “Over any year, companies may not reach the level of production they expect. This can be because of strikes and floods, for example.” The rises do not mean volatility in commodity prices has come to an end, however. By 8 June 2007, for example, the price of nickel had slipped back to $42,900. Furthermore, there is no direct link between commodity prices and the share price performance of commodity companies. Mr Henderson says commodity prices were up around 40 per cent last year and earnings went “through the roof” in 2006, but share prices in the sector did not increase significantly. In one year to 7 May 2007, the DJ-AIG commodity index fell 5.81 per cent and the GSCI Commodity index was down 21.84 per cent, according to Morningstar. This was partly because investors seemed to doubt the sustainability of commodity prices. The performance of commodity funds can vary substantially, partly depending on which part of the market they invest in. Over one year to 7 May 2007, for example, the Merrill LIIF World Mining fund returned 19.57 per cent. In contrast, the Fortis L Commodity World fund returned -20.63 per cent. Karin Schoeman, manager of the Fortis L Commodity World fund, says its performance over the past year has been negatively affected by the fall in the price of oil in August 2006. “The fund has the GSCI index as its benchmark,” says Ms Schoeman. “The weighting to energy in this index is typically between 55 and 70 per cent. This means the fund will always have a significant exposure to energy. “Therefore, the energy price falls of last year have affected performance. Other funds in the sector benchmarked to the AIG index will not have such a weighting to energy. “If our positive view of energy for the rest of this year is right, however, then we will benefit more than some other funds in the sector.” Ms Schoeman says energy prices have risen since January 2007. She says this reflects the market moving from over-supply at the end of 2006 to a “more balanced state following several rounds of OPEC production cutbacks”. She adds: “Another driving factor is tightness in the US gasoline market that has resulted in a rapid drawdown of inventories. Factors that have caused this tightness include strong demand and lower imports to the US, mainly from Europe. There have been strikes and unplanned outages at European refineries. “Fundamentals for the energy market are positive for the remainder of 2007. Furthermore, expectations of another hurricane season should bolster oil prices in the second half of 2007.” Ms Schoeman is also optimistic about base metals. She says base metals rallied in the first half of 2007 on the back of strong demand and restocking from China. Biofuel demand “The supply side is still hampered by bottlenecks, strikes and disruptions,” says Ms Schoeman. “This is delaying supply to the market, resulting in a drawdown of global inventory from an already low level. “Base metals are not as tight as during the past two years. Supply is resp�onding to higher prices but fundamentals remain positive and should continue to underpin base metals prices.” Soft and agricultural commodities are an area currently sparking interest. Ms Schoeman says agricultural commodities are rallying on the back of the expectations that the demand for alternative fuels (ethanol and biofuels) will result in global shortages. “Early indications, however, are that we are on our way to a bumper corn crop in the US,” says Ms Schoeman. “This may be a risk to corn prices during the summer, bar unexpected developments like drought.” Nevertheless, prices are also being driven by demand for food. Each year, the world has an extra 50 million to 75 million mouths to feed at a time when world food inventories are at historically low levels. China’s agricultural imports, for example, more than doubled between 2001 and 2004 to reach $33bn. US food prices rose at an annual rate of 6.7 per cent in the first quarter of 2007. If it continues for the rest of this year at this pace, it would be the biggest increase since 1980. China had food inflation of 6.2 per cent in the first quarter of 2007. Mr Blake says one way to play the soft commodities theme is to invest in providers of seed, fertilisers and agricultural equipment like tractors. He is optimistic about the outlook for commodities generally. Mr Blake says the world is in year five of a commodity cycle, but he stresses it differs from other cycles. Asia emerges “The big difference is the emergence of China and India,” says Mr Blake. “There are countries in Asia emerging just behind China and India. It is having a similar effect on the global economy and commodities to the emergence of Japan and Korea after the Second World War.” Evy Hambro, manager of the Merrill Lynch World Mining fund, also believes the outlook for the commodity sector is positive. He argues that the economic growth of emerging markets like China, India, Russia, Brazil and the Middle East is driving the growth in demand for commodities. There is little sign of a slowdown in demand for commodities, according to Mr Henderson. As long as the global economy continues growing then demand should be maintained. He believes uranium offers an investment opportunity, particularly as an increasing number of countries look at using nuclear power. Mr Henderson says big mining companies, such as Rio Tinto and BHP Billiton, have exposure to uranium. Duncan Goodwin, co-manager of the Martin Currie GF Global Resources fund, believes that in the short term, commodity markets will be volatile, “which is why we focus on stocks. In my view, calling the commodity cycle is a thankless task that most get wrong.

‘One of the key advantages of the resources sector is that it is highly diverse, both geographically and in terms of share price derivers. We have positions across most areas of the resources universe’ - Duncan Goodwin, Martin Currie

“One of the key advantages of the resources sector is that it is highly diverse, both geographically and in terms of share price derivers. We have positions across most areas of the resources universe, ranging from UK integrated oil to Korean dry bulk shipping.” One concern of investors is whether they have missed most of the returns from the commodities sector. Mr Hambro, however, says valuations of commodity stocks are still attractive. He points to the fact that Rio Tinto, for example, is on less than 10 times earnings. “This at least partly reflects the cautious view on the outlook for commodity prices,” says Mr Hambro. “We believe Rio Tinto should be trading on around 20 times earnings. Rio Tinto is paying an attractive dividend, has no debt, is buying back shares and is profitable. It is on a discount of 25 per cent to the FTSE 100. Some companies are trading on four or five times earnings.” Mr Goodwin says the Martin Currie GF Global Resources fund is unconstrained by benchmarks. He says a way of trying to add value is by speaking to suppliers, customers and joint venture partners. Three steps to change When choosing stocks, Mr Goodwin says the starting point is positive change. “It must be sustainable, rather than a one-off, and company-specific rather than purely macro-driven. “To ensure the change will move the share price, we look at three additional factors. First, expectations for cash flow. We need to see the potential for a positive move in cash flows against current expectations. “Second are attractive valuations. We need to see at least 20 per cent upside to the current share price to invest in a company. Third are growth expectations. We want to see a series of positive earnings revisions as a result of the change.” The Martin Currie GF Global Resources fund returned 100.87 per cent over three years to 7 May 2007 compared with 4.94 per cent by the Dow Jones-AIG Commodity index. Mr Henderson says a lot of outperformance of the JPM Global Natural Resources fund has come through selecting small caps. The fund returned 13.52 per cent over one year to 7 May 2007 against -5.81 per cent by the Dow Jones-AIG Commodity index. It can invest across all capitalisations in the market, but Mr Henderson adds that large mining companies cannot deliver the same level of growth as small caps.

‘Small caps have the potential to grow by 200 to 300 times. In selecting stocks, we look for companies with undiscovered value’ - Ian Henderson, JP Morgan

“Small caps have the potential to grow by 200 to 300 times,” says Mr Henderson. “In selecting stocks, we look for companies with undiscovered value.” One way to add value is through discovering more reserves, extracting more oil, gas or ore, for example, and by extending the life of mines. “One of our holdings in Australia, for example, has secured further nickel reserves over the past few days,” he says. “This could increase the value of the business by 30 to 40 per cent.” Mr Blake says he has one analyst working with him on the fund. But he calls on the views of 11 investment professionals working around the world in the energy and resources team. Mr Blake says he takes both a top-down and a bottom-up approach to managing the fund. The top-down assessment identifies sectors offering the most attractive growth prospects and valuations, at least partly based on supply and demand. He then selects the most attractive stocks within these sectors. Mr Blake looks for stocks under-valued relative to his growth expectations. He also invests in companies that he believes are in turnaround situations. Mr Blake uses five main criteria to select stocks. These include whether companies can deliver growth surprises. How strong are companies’ balance sheets, and are they undergoing financial restructuring? Currency is an important consideration, says Mr Blake, as it can affect a company’s profits. Mr Hambro says this is because revenues are typically in US dollars while costs are in another currency. The weakening dollar has proved inflationary for commodity prices. Mr Blake asks companies if they use hedging strategies. Mr Blake also assesses management and do they have a clear strategy. Finally, he evaluates whether the previous factors are in the share price and how the price compares with companies’ peers and the market in general. The Baring Global Resources fund returned 120.20 per cent over three years compared with 4.94 per cent by the Dow Jones-AIG Commodity index.