Assets Race to the Bottom

Which asset class will find the bottom first? Will it be commodities, property, ore shares? And which shares?

Local shares got a big yesterday, especially the miners. The good news came from the ACCC's approval of BHP's merger with Rio Tinto. It was a bit of surprise that the ACCC said the merger would not lessen competition in the iron ore industry.

But maybe it shouldn't be that big of a surprise. Except for Fortescue, BHP and Rio pretty much have all the best ore deposits and infrastructure in the Pilbara locked up. If they eventually do tie the corporate knot, look for an accelerated move to a new pricing system for ore based on an index and not on annual negotiations.

Besides, there are plenty of juniors scurrying around the Pilbara and Midwest. Economies of scale come into play. Smaller deposits can be developed and sold to smaller Asian steel producers. You just have to pick the right projects.

Has the logic of a merger between Australia's two largest mines changed with the credit crash? The whole point of the deal, from BHP's perspective, was to buy current and imminent Rio ore production to take advantage of the China boom now (not later). Rio is closer to big production increases in iron ore than BHP. It's earnings growth by acquisition.

But the whole strategy only makes sense if you think Chinese steel production will keep growing. Both Rio and BHP clearly think it will, and have backed that view with capital investment in new projects. The hitch in the plan is whether the credit crunch is going to derail the China boom. Right now it's just slowed it down through falling share prices and a tighter market for available capital.

So will the credit crunch derail the resource boom? That's exactly the question we'll be tackling at the Melbourne Investment Expo next weekend. We'll give you a sneak peek at our answer: No! In fact, despite some gloomy reports in the local press, there's simply isn't a lot of evidence yet that industrial demand in China (driven by urbanisation and industrialisation) is headed off the cliff. Just the opposite, in fact.

However the best strategy for investing in the boom-if you accept the thesis is still valid-is trickier now than it was just a few years ago. At $32.75, BHP is trading just above its 52-week low of $30.85 and well below its 52-week high of $50. The price is low. But is it right?

That depends on how much earnings will grow this year. And THAT depends on commodity prices (iron ore, coal, oil, and the like). It's complicated.

Luckily, Al Robinson across the office is making it a lot easier. He tells us that the market is setting up for the mother of all rebound trades. But he says the most promising shares are not the big blue chips, but the mid-level producers and even some junior explorers that have great projects. Why?

The smaller producers and explorers can ride out a downturn in resource prices by closing up shop for awhile and waiting for a rebound. That isn't good for cash flow, of course. But they key factor, according to Al, is whether you have the tangible assets in the ground or not. Many of these small firms do. That what makes them such great value plays (especially compared to financial share, where asset quality is so much more opaque). Al calls them "Pebbles." BHP and Rio are, logically, Bam and Bam.

Why are we yammering on about the resource market when everyone wants to know what the U.S. Senate is going to do? That's easy. The Senate is full of rich men and women who have rich and powerful campaign donors. They will do the least controversial thing that requires the least amount of thought and vote to spend other people's money on Wall Street's problem.

It's the House you should watch on Friday night. That bunch is completely unpredictable.

Besides, as an investor, we're more interested in the shares everyone is ignoring. Traders are especially interested in the rubble of the Aussie resource sector. Gabriel André-who sits across from me at the Old Hat Factory-has refined a technical screen for identifying oversold resource shares. He calls it the Swarm. We have no idea what he means. But he's pretty excited about it.

Not so exciting was the news yesterday that U.S. auto sales fell 27% in September. It was the worst one-month fall since 1991, which just so happened to be the last time the U.S. had a real recession. What do you think it means? We agree...it's a recession. The American consumer is rolling over.

Lots of reader mail last night on our special edition. One recurring question: is the Paulson plan designed to unfreeze the credit markets or recapitalise the banks?

Why not both? If it only succeeded in removing dodgy assets from bank balance sheets, the Plan might improve the creditworthiness of troubled banks. That means banks could be both borrow from one another and lend to businesses and individuals again. If, that is, the Plan removes a sufficient amount of impaired assets to improve creditworthiness. That's a BIG if. There's a whole lot of impairment out there.

It's also clear that Paulson wants to unfreeze the money market and the short-term debt market. Remember, the money market is the source of working capital to American (and Australian) businesses. Companies borrow short-term to finance essential operating activities like payroll and inventories. This is, perhaps, why George Bush told Americans, "Our entire economy is in danger."

It's sort of true. Businesses that finance payroll through borrowing are certainly in danger. So are their employees. You can see how the whole thing COULD mushroom. But for our part, we'd be more interested in businesses that can finance operations through cash-flow and not borrowing. That seems like a better investment lead for the times we live in.

But it's not just unfreezing the inter-bank lending market that's important. None of it matters if the banks aren't recapitalised. Ultimately, we believe that's the ultimate goal of the Plan. It's also clear, based on the remaining sea of bad mortgage and asset-backed debt out there, that US$700 is just a down payment on future instalments to rebuild the balance sheets of sick banks. More money will be needed, and Congress, having agreed in principal, will have a hard time saying no once the process begins.

Why not just let the troubled banks fail? Will it be the end of the world? Many U.S. banks simply don't have enough capital to maintain their current portfolio of assets (falling in value). How will these banks even begin to make new loans while their capital continues to evaporate?

As we mentioned yesterday, the market is wary of providing capital at these prices. Private equity has already been burned pumping money into banks that burned it up quickly with asset write downs. So why try and catch the falling scimitar? Why not just offer the banks what you're willing to pay and wait them out?

Paulson and the Congress offer the American people the "hand of friendship" with one hand and the "whip of calamity" on the other, to borrow a phrase from Rudyard Kipling. But is it such a clear cut choice between disaster and salvation?

If we consider the current banking system as a patient on the operating table who has suffered massive head trauma and internal bleeding, it's easier to see what should happen. Paulson wants your blood for continuous transfusions. The patient is kept on life support, although his brain is likely to remain permanently dysfunctional.

Meanwhile, in the waiting room, there are private investors happy to buy a liver, a kidney, some corneas, and maybe even a lung or two. But you can see the problem. For the buyers to be interested, the patient has to die.

Paulson, Bernanke, Bush, and Congress need to pull the plug and let nature take its course. That's not what publicly elected officials do, though, especially so close to an election. So we will get Frankenstein. And you know what happened to that poor, unnatural creation of human hubris don't you?

Dan Denning
The Daily Reckoning Australia

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