Issue: 107
Sent: 22-04-2008 11:54:01
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Independent? Expert? No Way!
There will be no more economic cycles and zinc prices will go up indefinitely according to independent valuation expert, KPMG. This is another failure to judge risks.
Equity analysts working for stock brokers and corporate advisers, credit analysts and funds management researchers do not have a distinguished track record in identifying good market value for investors. In practice, their recommendations are influenced far too heavily by prevailing sentiment, limiting their usefulness for advisers seeking to make forward looking judgments.
There is evidence that broking analysts tend to recommend selling stocks after they have fallen. Similarly, fund researchers react to events. Most recently, credit analysts began to eschew subprime investments only after anyone reading a newspaper had pretty much come to the same conclusion.
In becoming hostages to the markets in which they work, analysts can easily lose their independent thought and, in the extreme, once compromised in this way, have no discernible expertise to set them apart from the herd in the street.
My prompt to explore this theme again was the release in the past week of an independent expert report relating to the takeover of Mineral Securities Limited by CopperCo Limited. This valuation raised several interesting methodological issues, only a few of which I am touching on here.
In this transaction, the bidder’s primary exposure is to the copper market while one of the target’s primary exposures is to zinc. Since consideration for the transaction was scrip in the bidder, the fairness of the transaction ultimately hinged on a view about relative price movements in these two commodity markets.
The independent expert, KPMG Corporate Finance in this case, valued Mineral Securities at between $386 million and $593 million, well and truly above its $154 million market capitalization last Friday. So, KPMG was seeing something the rest of the market had missed.
Of the putative value of the target, one third was attributed to a 25% stake in a zinc mining project in Queensland. This project has been around for, literally, decades without anyone having the commercial courage to initiate its development. Zinc prices have never been high enough for long enough to compensate for the technical challenges.
The mine’s potential cash operating costs are put at 71 cents per pound of payable zinc after $195 million is spent on development. Without seeking any return on 20 years of past expenditure, this suggests a zinc price in the vicinity of 85 cents per pound or US80 cents per pound would be needed for economic break even. With zinc prices currently hovering around US100 cents per pound, virtually any weakness in the zinc market could be catastrophic for the prospects of this mine, given how quickly these prices can move.
Fortuitously, the independent expert believes that today’s price, escalated by an inflation factor, will prevail forever. And the expert cites the forecasts of others to justify this assumption. Moreover, judging from his assumed pattern of prices, the expert also apparently believes that price cycles will cease for the life of the mine.
Meanwhile, the expert has also opined that while zinc prices are rising, copper prices are going to fall by 30%. The expert could be right but he fails to mention that this view of the world flies in the face of our historical experience.
Since 1980, copper and zinc prices have failed to move in the same direction over any 12 month period only 32% of the time and have failed to move together over any 24 months only 22% of the time.
In other words, the combination of circumstances put forward by the expert in justifying an investment decision relies on a specific and unusual evolution of markets. This highly dangerous practice has brought a succession of investment products unstuck.
In an interview on ABC television on 9 April, the head of corporate and government ratings at Standard and Poor’s conceded that, in the aftermath of the industry’s failure to tip the subprime market failure, his organization has had to do things differently. The changes made by Standard and Poor’s will include more emphasis on scenario analysis, for example, so that users of research can understand more easily the risks applying to investment decisions being contemplated.
Analyzing the risks meaningfully is different to listing them ritualistically in a way dictated by lawyers as so often occurs in Australian disclosure documents. Only when analysts begin understanding the risks themselves and displaying them explicitly within a decision making framework will they begin helping advisers to understand the investment decisions they are confronting.
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