The Other Edge of the Inflation Sword


— There are only a few ways a company can grow the actual – or intrinsic – value of its business. It can reinvest earnings to increase assets and shareholder equity, while maintaining profitability. Or it can increase profitability by becoming more efficient.

— By ‘profitability’ we mean return on equity. Generating a sustainable increase in return on equity (ROE) is, or should be, the Holy Grail for business managers, large or small. High ROE enterprises tend to be rewarded with higher share prices.

— That’s because they are worth more. Let me explain…

— You have two businesses, both earning $10m a year. But Business A only employs $20m in equity capital while Business B employs $100m. Business A therefore generates a 50 per cent ROE while Business B can only manage a 10 per cent return.

— Clearly, you would prefer to keep Business A as it generates the same profits as B, but for much less capital invested. If these companies were listed on the market, Business A would, or should, trade at a much higher price than B.

— Which brings us to BHP and its $23.6bn profit. The company started the year with $49.3bn in equity capital, so the profit represents a return on that equity of 47 per cent. At the start of 2007, just as the first commodities boom was getting into full swing, BHP had just over $24bn in equity capital and generated a 55 per cent return on that capital.

— So you can see that while BHP’s profitability has dropped slightly, it has doubled the size of its business in terms of the capital invested. Oh… and this year it also generated around $14bn in free cashflow – that is, cash available for use AFTER all capital investment needs were taken care of.

— Usually, this type of performance would be rewarded with a higher share price. But in BHP’s case, it has pretty much done nothing over the past five years. For a company that reinvests a large portion of its massive profits and manages to maintain a high return on that reinvested profit, such share price behaviour is bizarre.

— According to Reuters consensus earnings estimates, BHP is trading on a FY2012 price-to-earnings ratio of just 8 times. For such a highly profitable company, this is a pretty low number and would indicate the stock is very cheap.

— But the market is not convinced. Why? Well, the chart below might provide some hints. It’s the Reserve Bank’s index of commodity prices and it is off the charts… almost.

RBA Index of Community Prices


— It is mainly the bulk commodities, iron ore and coal, driving this chart parabolic. And these two commodities provided 50 per cent of BHP’s operational earnings in 2011. It would have been more if not for the flooding in Queensland, which impacted on coal production.

— BHP’s Iron Ore division generated $13.3bn in operational earnings, which represented a ROE of around 95 per cent. Metallurgical Coal produced $2.67bn in earnings and ROE of 57 per cent.

— Clearly, these two divisions produce much of BHP’s earnings and do so at a high rate of profitability. And not surprisingly, judging from the vertical nature of the chart above, the market does not believe such earnings and profitability will be maintained. It senses, correctly we’re sure, that coal and iron ore prices especially will not be as kind to BHP in the coming years.

— How far will bulk commodity prices decline? That all depends on China. In its economic commentary in the annual results release, BHP said the following:


‘Across the important growth economies of China and India, recent economic data suggests monetary policy is having the intended effect. That said, growth in fixed asset investment in China has remained resilient and is yet to fully reflect the recent policy response.’


— That’s because China has been in a fixed asset bubble for years. One characteristic of bubbles is they continue even when policy begins to ‘lean’ on the bubble. Think about the US housing market. It continued to inflate for years even as the Fed began to tighten monetary policy.

— One day something happens – a minor catalyst – and the bubble begins to burst. The same thing will happen with China’s iron ore and coal intensive fixed asset bubble.

— But in the meantime, the party rolls on. In further evidence that excess money needs an outlet in China, we read this headline recently in the FT:

‘China to launch first wine investment fund’.

— Investing in anything other than high quality, low quantity premium wine is fraught with risk. This type of ‘investment’ only becomes available when there is an ample supply of money looking for a home – and that money doesn’t care much about how it is accommodated.

— Getting back to BHP, the market appears to be pricing in a pretty decent fall in bulk commodity prices in the year(s) ahead. In other words, it’s factoring in a China slowdown. Not a crash… a slowdown. But because of management’s focus on only investing in ‘Tier one’ assets, BHP should continue to generate above average returns on equity across its projects for years to come.

— This task will be made easier by central banks and governments around the world, who will always stand ready to fight deflation by trying to engineer inflation. And in this respect BHP is up there with the banks in getting first use of any new money a central bank creates.

— When central banks monetise debt, they push newly created cash through the financial system. The bankers clip the ticket first, but then the money flows into real goods – like the stuff that BHP digs out of the ground. So BHP quickly converts its goods into cash. Only afterwards does the inflation catch up to the company on the cost side.

— It mentioned this aspect of the business in its annual results:

‘BHP Billiton has regularly highlighted its belief that costs tend to lag the commodity price cycle as consumable, labour and contractor costs are broadly correlated with the mining industry’s level of activity.’

— So there you go. BHP is one of the first beneficiaries of inflationary policy. But the other edge of the inflation sword comes back to bite it when it invests to expand production based on the higher price signals the inflation gives. This is the higher ‘consumable, labour and contractor costs’.

— Of course the bankers have no such problem. They get first use of the money and little need to reinvest. The only inflation they must deal with is their own salaries – a small price to pay.

— The message here is inflation only benefits society’s ‘privileged few’. Yet the world will wait in thrall tonight for Ben Bernanke to speak. And it will hope that he speaks of an ongoing inflationary policy.

— It sounds insane, but when you have such influential opinion makers like arch Keynesian Paul Krugman screaming out for more stimulus, it’s not surprising that so many people think more money printing will actually work this time.

— To prepare you for Bernanke’s speech tonight, we’ll leave you with this piece of wisdom from Krugman, written for the New York Times in 2002:


‘The basic point is that the recession of 2001 wasn’t a typical postwar slump, brought on when an inflation-fighting Fed raises interest rates and easily ended by a snapback in housing and consumer spending when the Fed brings rates back down again. This was a prewar-style recession, a morning after brought on by irrational exuberance. To fight this recession the Fed needs more than a snapback; it needs soaring household spending to offset moribund business investment. And to do that, as Paul McCulley of Pimco put it, Alan Greenspan needs to create a housing bubble to replace the Nasdaq bubble.


— PS – Thanks to an informed reader from Colorado, you are now one of the few people in the world who know that Bernanke’s speech will come to you from Jackson, not Jackson Hole.


Although Jackson Hole is a Best Western Hotel in Jackson, Wyoming, there is no place on the map where these crooks from the Fed will meet called Jackson Hole.

It surprises me that even you gentlemen have fallen for the main stream media’s moniker just like every other news outlet. I guess that’s news today. Get in line, stick your nose in the last guy’s butt and follow the “leader”. That’s the only hole this meeting of economic “midgets” and their sycophants will really be attending.

The meeting will be held in Jackson, Wyoming, not Jackson Hole.

Please make this distinction to your readers.


Well said…have a good weekend.

Greg Canavan
for The Daily Reckoning Australia


Publisher’s note: Jackson Hole speech imminent… for a heads up on how the market could react, go here.

Murray Dawes has been spot-on with his market predictions over the last three months. One subscriber to Murray’s free YouTube channel calls him “scarily accurate”. Another says “you are well on the money…”

In Murray’s latest free video he shares his view on Bernanke’s key speech and its likely outcome… Our resident trader’s conclusion might disappoint some investors hoping to see a rally…

Whatever happens, you’re going to want to know two things: what key level on the ASX Murray has targeted for action… and what action to take if that level is breached.

Find out the answers to both these questions – for FREE – in Murray’s latest YouTube market update. Watch it here.


Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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