Sent: 30-03-2011 11:52:04
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BHP is Compulsory
BHP Billiton is turning into a compulsory investment for most Australians as portfolio constructors stick with history and eschew the logical implications of their analysis.
My comments this week about BHP Billiton have been prompted by discussions I have had recently with several researchers responsible for constructing Australian equity portfolios for retail investors.
Australian investors have a strong and long held attachment to BHP Billiton. Despite the number of South Africans now populating its ranks, the company is regarded fondly for having been a stalwart of Australia's industrial development for over a century.
The high regard in which the company is held has been assisted by an annual rate of increase in its share price of 12% over 20 years (although over the first 15 years of this period, the rate of increase was only 7% a year).
All but one of the researchers with whom I spoke were of the view that commodity prices would be lower in three years time than they are now. This would have serious repercussions for BHP Billiton. Cyclical changes in commodity prices are rarely gentle. The fall, like the preceding rise, is usually a large double digit percentage change.
BHP Billiton reported an outstanding US$10.5 billion net profit for the six months to December 2010 implying an annual rate of profit of around $21 billion. However, most of this would be lost in a normal cyclical downturn. Based on the company's own analysis of its earnings sensitivity, a 30% fall in the prices of its principal commodities would slash its full year earnings by $12.5 billion, everything else being unchanged.
The researchers also accepted that BHP Billiton faces some important strategic challenges including how to make up for a declining resource base that will heavily constrain its future growth rate. While, by conventional standards,it is financially strong, acquisitions big enough to make a meaningful impact on its potential growth rate are rare.
Against this background, the researchers also agreed that any company in another sector facing similar prospects would be shunned.
Despite this outlook, all the researchers were committed to retaining BHP Billiton in their model portfolios. The reasons for this course are essentially the same as for other investors, namely, the historical background to it being Australia's largest industrial company and, now, the world's largest mining group.
BHP is, quite simply, the cuddly teddy bear of the Australian equity market. It offers great psychological comfort and is often retained by adults simply for the memories it brings of simpler times.
In constructing their portfolios, researchers face another constraint. There are internal corporate pressures to limit their use of investment products that may be perceived as out of the investment mainstream or which challenge investment orthodoxy.
Some of these pressures have become more acute since 2008. The larger corporates do not want their names sullied by an association with a failed investment product. They would prefer to deliver a lesser investment return to their clients than risk this possibility.
The determination of fund managers to stick with the mainstream was also highlighted in the past week by a large feature in The Weekend Australian Financial Review ("Reduce your risk in resource plays", page 45, 19-20 March) discussing resource sector investment funds.
The article compared the composition of four of the resource sector funds available to retail investors in Australia. The four are offered by Perpetual, Colonial, Global Mining Investments (and managed by Black Rock) and Officium Capital (and managed by E.I.M. Capital Managers).
The Officium fund is the odd one out. Not only is it managed by a fund management minnow but, according to the AFR, all the others included BHP Billiton, Rio Tinto, Xstrata and Vale among their largest portfolio holdings. None of these were in the E.I.M. portfolio.
At one level, there is a clear choice here between the E.I.M. approach and the others about where the better investment returns are to be had. At another level, there is no choice: stick with a large, well established manager and you must buy BHP Billiton (and Rio Tinto, etc).
Again, there is pressure to construct portfolios without regard to what is in the best interests of investors. In this instance, large institutions need to buy stocks with large market capitalizations. Otherwise, the pool of funds being managed will not be big enough to cover their overheads.
John Robertson's superannuation fund owns shares in BHP Billiton and he is a member of the investment committee of the Emerging Resources Company Share Fund managed by E.I.M. Capital Managers of which he is also a director.
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