I’ve just returned from a week away with the family. We spent it in Vern Gowdie territory, at Broadbeach on the Gold Coast. It’s a great spot for kids and families.
What’s with the lack of daylight saving though? Seriously, Queenslanders with young kids must be among the most sleep deprived in the world. First light is about 4.15am. By 5am, the sun had infiltrated every part of the room, despite the curtains been drawn.
My two year old came into our room and happily announced ‘it’s morning time’ around 5am each morning. Thankfully the beautiful views from the rooms took away some of the pain.
Apart from the vile and murderous terrorist actions in Paris, the biggest thing to happen while I was away was the continuation of the theme of falling commodity prices.
Copper, gold, iron ore, oil…all continue to head south, at least in US dollar terms. It’s not quite as bad in Aussie dollar terms but the market doesn’t seem to care about that distinction right now.
And anyway, it’s hardly good news. The broad CRB commodity index, priced in Aussie dollars, is at multi-year lows. And this index doesn’t even take into account the price of bulk commodities (like iron ore) that are most important for our economy.
Iron ore is approaching the lows reached a few months ago. It’s only a matter of time before you’ll see the price drop into the US$30 tonne region. China’s old, commodity intensive economy is on an inexorable slide. It will continue for years. The only question for investors is how steep the slide will be.
So far, it’s been difficult but manageable for Australia. So manageable, in fact, that the mainstream view is that Australia has weathered the storm and that we’re rebalancing away from mining investments to other sources of growth.
Other sources of growth meaning building houses and apartments and services actively involved with speculating in housing and apartments. That sounds sustainable…
But we could be due for another bout of China induced fear. At least that’s what Goldman Sachs thinks after studying the recent activity in the Chinese metals market. Via the Financial Times’ Alphaville:
‘…since late October there has been an eye catching rise in Shanghai Futures Exchange open interest across the metals complex – for copper, it has been the largest increase in Shanghai open interest in 12 months – since the 1Q15 collapse in Chinese metals demand. In our view, this development raises a red flag regarding ongoing and near term activity in China’s ‘old economy’ and metals demand growth, as measured by our GS China Metals Consumption Index.
‘Indeed, over the past five years, periods of rising SHFE open interest and falling metals prices have been associated with concurrent or imminent weakening in China’s commodity intensive “old economy”.’
If the past relationship holds, metals consumption in China is about to take a hit. The question is whether such an outlook is already priced in.
In the short term it could be. But in the long term it’s unlikely.
To explain why, let’s have a look at BHP Billiton [ASX:BHP]. Over the past few weeks, as the Big Australian hit new, multi-year lows, many investors and commentators have come out in support of the stock.
According to many, BHP is a screaming buy. They cite an 8% plus yield in support of their argument.
Maybe BHP shares are cheap. But when you use the yield argument on a mining stock, you’re clutching at straws.
The only reason BHP trades on a yield of more than 8% is because the market is pricing in a cut to the dividend. According to consensus earnings estimates for 2016 and 2017, earnings per share will be $0.86 and $1.27 respectively. Dividends per share forecasts are $1.83 and $1.81 respectively.
Can you see something wrong here? BHP is paying out more in dividends than it is earning. It’s borrowing to make up the difference. While it’s true that BHP can cut back on investment to help fund the dividend, such a move would come at the cost of future growth.
The smart strategy for a cyclical company like BHP would be to set dividends as a percentage of earnings. As in, we commit to paying 50% of our earnings out as dividends. This ensures the company maintains an affordable dividend strategy. When earnings fall, dividends fall too.
But instead, BHP’s board let the commodity boom go to their heads. Years ago it announced a ‘progressive’ dividend policy. This stated that dividends would increase or remain stable each half year.
With the Annual General Meeting coming up on Thursday, BHP has an opportunity to change their dividend policy. Will they do so? Who knows? Egotistical boards are reluctant to admit mistakes. So I would be surprised if they concede defeat and return to a more sensible dividend policy.
The bigger question is: should you buy BHP? Is this the bottom of the cycle for earnings or is there more pain to come?
There are two ways to answer. The first is through standard fundamental analysis. That is, does BHP look like good value? The problem with this method is that diversified companies rarely look like good value at the bottom of the cycle.
For example, based on 2016 earnings forecasts, BHP trades on a P/E multiple of 23.7 times. Compared to the market average of around 14 times, that’s expensive. But if earnings rise strongly from here (as they usually do when coming off a cycle low) then the current price is actually cheap.
And consensus forecasts have 2016 as the earnings nadir for BHP. Earnings per share are expected to increase from $0.86 this financial year to $1.80 in 2018. That’s a 100% increase in two years.
In my view, that’s way too optimistic. BHP earns the bulk of its profits from iron ore. Given China’s precarious economy, there’s a much greater chance of seeing an ongoing iron ore price bust over the next few years rather than a recovery.
So fundamentally the picture is clouded. To clear things up, I turn to the charts. And right now the chart is telling you to stay away. Have a look below.
[click to open in new window]
Sure, BHP is due for a bounce. It’s oversold. The same thing happened in August and September. But as you can see, the main trend is still down. There’s no evidence here of a cyclical bottom in earnings.
In The Daily Reckoning on 4 August, I wrote the following:
‘While BHP may be attempting to bottom right now, the path of least resistance is unequivocally down.
‘The odds favour this downtrend continuing and I wouldn’t be surprised to see BHP break through support at $25 and make new lows in the weeks or months ahead.
‘I’ve discovered from painful experience that buying in the face of a downtrend is like swimming against a current. It’s tough work and there is a low probability of success.
‘You’re far better off to wait for the downtrend to exhaust itself and for a new turnaround to emerge before getting involved.
‘So if you’re tempted to buy commodities at this point, go jump in a river and try swimming upstream. Then, lay on your back and let the current take you. How much easier is that?’
Notice I didn’t give my opinion on the dividend, management, earnings, or commodity prices. All these opinions are in the price. All you need to do is observe the price and discern the trend.
Nearly four months later, nothing has changed. BHP’s price trend remains down. Buying against this trend is a low probability trade. If you want to increase your odds of success, wait for the trend to turn before buying.
It really is quite simple.
I’ve taken advantage of this type of analysis for subscribers of Crisis & Opportunity. We’ve been ‘short’ BHP (meaning we profit from price falls) for over a year. Currently we’re up about 40% on the trade.
The direction of the trend tells me there’s more gains to come. To find out more about this investment methodology, click here
For The Daily Reckoning