Recent performance numbers by South African equity managers are being heavily influenced by exposure to the most cyclical part of the market, commodity or resource shares. Some managers have taken big bets on the sector and are suffering, whilst others continue to stay away. This note will explore how we see the risks and opportunities in this very volatile sector of the market.
The chart below was extracted from a global macro investment blog highlighting the head and shoulders formation of the global commodity index. Despite the very sharp fall the author expects significantly more downside, a scary thought for anyone invested in a commodity producer.
We are not guided by technical factors, but have spent a lot of time thinking about the sector. We have tried to remove ourselves from the noise of daily price movements and think deeply about the fundamental outlook for the next 3-5 years. With current commodity prices at their lowest levels of the last 10-15 years, most companies will require much higher prices to produce an adequate return for investors.
Given the low level of expectations in the sector it has natural appeal to anyone with a contrarian mindset. Despite the negative sentiment and very low expectations, we remain of the view that one needs to approach the sector in a circumspect manner. Recent experience will remind investors of a very strong rally in commodities post the financial crisis, but this was on the back of an extreme, credit driven binge in China, something that is unlikely to be repeated. The recent rout in commodities has been very widespread and it is difficult to find a single commodity that has held its ground.
Commodities – percentage drop from peak
￼Going forward we think the outlook will vary from commodity to commodity, in line with their individual supply and demand fundamentals. It is possible that some may have entered an environment of structurally lower prices, where as others will see a cyclical recovery in the years ahead. As an example, it is possible that the significant increase in supply of iron ore and oil could lead to lower prices for a long time. We do not know if this is true, but we do see it as a risk to an investment in the more popular commodity counters that make up a large part of the index, i.e. Sasol and Billiton.
Sugar is a commodity that is facing severe cyclical headwinds, but we believe that in time the cycle will turn and production will adjust to lower prices. It is also a commodity with a very smooth demand profile, particularly in growing regions like Africa, where Tongaat Hulett (Tongaat) is increasingly focusing its sales efforts.
Sugar – steady demand, currently oversupplied
Thankfully for Tongaat their property and starch and glucose divisions are very profitable, enabling the company to continue investing into a poor sugar cycle. The property assets in Kwazulu Natal may produce lumpy earnings, but they are a unique asset and will produce solid cash flows in the years ahead. While these cash flows are currently supporting a poor sugar cycle, at some stage we expect more of them to flow back to shareholders as debt and sugar capex peaks. When the sugar cycle does eventually turn (we have no foresight as to when that might be), current investments will result in greater production at a lower cost per unit of production, leading to improved profitability.
Tongaat Hullett – unique property assets with strong sales momentum
In Tongaat, our largest holding in the commodity sector, we are buying into a depressed commodity cycle, but we are doing so in a prudent manner. We are buying a commodity with a very smooth global demand profile (not just China), but the margin of safety is also supported by strong cash flows in other divisions that are not tied to the commodity cycle.
The wild card – the US dollar
Weak growth and excess supply has hurt commodity prices, but a resurgence in the US dollar has played a significant role as well. Speculators in particular are increasingly betting on this inverse relationship.
Further strength in the dollar is something that we view as a very real possibility, particularly as the Federal Reserve contemplates a “less easy” monetary stance. Should this happen it may well put further pressure on commodity prices, albeit these will be partly shielded by a weak rand. While we do not try and base investment decisions on currency movements, we do bear this potential outcome in mind, particularly when monitoring position sizes. We are also of the view that a significantly stronger dollar would possibly have a larger impact on the prices of some of the more popular areas of the market, even though they may not have a direct link to commodity prices.
The current downturn in the commodity sector is extreme and frightening. One only has to look at the muted job cuts in the sector to get a sense of the severity. Local resource shares are increasingly pricing in this very poor cycle, creating potential opportunities for investors who are willing to take a long-term view, as opposed to trying to time the bottom of the cycle. We are spending significant time and effort looking for ways to buy depressed assets in the sector, but will continue to do so very selectively and apply strict risk controls around our exposure to the most cyclical part of the market.