Sent: 13-06-2013 09:18:03
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Mining companies no longer diversified
Changes in industry structure have caused global accounting firm PwC to question whether large, diversified mining houses still exist. Any investment adviser or portfolio modeller who recommends an investment in a diversified miner may be suggesting the impossible but, whatever the motivation, it is still happening.
In a report on the global mining industry published on 5 June, top 4 accounting firm PwC analysed financial outcomes for the 40 largest global mining companies. Among the characteristics noted by PwC was the growing extent to which companies were losing their diversification attribute. PwC reported that 56% of the revenue of the five largest diversified mining houses came from iron ore and copper in 2012 and 73% of revenue came from these two commodities and coal.
The spread of profits is even more concentrated. Copper and iron ore earnings account for 78% of the combined profits of BHP Billiton and Rio Tinto, for example, the two critical stocks in the Australian market.
A recent research report from one of Australia's leading institutional broking firms recommended that its clients sell the banks and buy the miners. The recommendation came after the difference in share price performance over the prior 12 months between bank stocks in the S&P/ASX 200 and stocks from the resources sector had stretched out to 57 percentage points.
The difference was unusually large. The performance gap has topped 50 percentage points on only three prior occasions since 1980 raising the probability of a reversion to more normal relative prices over the coming year, if history was any guide.
The case for the sectoral switch came with a recommendation to sell Westpac and buy BHP Billiton. A recommendation to buy BHP does not mean BHP offers the best prospective returns in the sector. Stock recommendations from the largest brokers will always focus on the largest stocks because soliciting business in small companies cannot generate enough revenue to cover overheads.
Investors as well as intermediaries are attracted to BHP's size. For buyers, size offers a sense of safety. The company's investment returns might flounder but, as a business, it is unlikely to fail in the short term because it accounts for such a large part of each of the market segments in which it operates.
The markets for iron ore or copper will probably never deteriorate to such an extent that BHP is unable to sell enough of what it produces to stay open. Even if unprofitable, it would have enough borrowing capacity to stay afloat.
BHP Billiton also occupies a prominent position in equity portfolios because it is widely regarded as a diversified mining house. This is one of the main arguments mounted in the research report recommending a switch from Westpac.
In theory, diversification removes a mining company's dependence on a single commodity price. Diversification raises the chance that, while one commodity price might be declining, others might be rising or not changing so as to offer greater earnings stability. This, in turn, should mean less share price volatility and a share price premium, other things being equal, to reflect the value of this attribute.
From the late 1980s, resources sector investment strategists started to differentiate between producers of bulk commodities like iron ore and coal and producers of base metals like copper and zinc. The primary rationale for this distinction was the way in which these two groups of commodities were priced.
Iron ore and coal prices were typically negotiated annually between Japanese buyers and one or two of the largest producers of each of the commodities. The base metals, on the other hand, were priced on a daily basis in open outcry markets in which news flow and short term financial market conditions combined with the most excited buyer and the most desperate seller to set prices. Gold and silver also fell into this category.
The different price setting environments meant bulk commodity prices tended to be less volatile than base metal prices. Statistically, there was a low correlation between price movements in the two market segments. Consequently, a company's earnings characteristics would differ depending on its mix of sales between bulk commodities and daily traded metals. Usually, when analysts are talking about diversification, they are referring to this bulk commodity/daily traded metals split.
This analytical distinction which has served stockbrokers for 20 years has lost importance since changes in commodity pricing arrangements in 2010 when producers of iron ore and coal moved to spot pricing of their sales in much the same way as nonferrous metal sales had been made.
As a result of the changes to the pricing regimes, the correlation between iron ore and copper prices has risen from near zero to as high as 85%. Such high correlations imply less diversification benefit from investing in a producer of both iron ore and copper, for example.
True diversification requires more than metals with different colours. Correlation between price movements is the principle determinant of whether diversification is financially meaningful.
Rio Tinto or BHP Billiton might remain appropriate investments for portfolios but the tendency to glibly recommend either because it is diversified (i.e. because it produces metals that look different) is naive, uninformed or possibly even deceitful.
Among the implications arising from the loss of commodity diversification in the leading miners is the need for portfolio constructors to modify the way in which they choose stocks. If one-stop diversification is no longer available, portfolio managers should be looking to choose a wider range of investments with different earnings characteristics so as to replicate the portfolio effect they had been seeking to achieve through the single investment.
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