24min read
PREVIOUS ARTICLE Why China is likely to end in ... NEXT ARTICLE 4 Coking Coal Stocks to Watch...

For well over a year commodities both hard and soft have been hammered.  While metals and energy earn the most attention from some investors and financial experts, commodities like cotton, sugar, and coffee have also suffered.  In theory, futures contract pricing should be largely a function of available supply of a given commodity and the demand for it.  Soft commodities suffer from weather concerns as well as from traditional supply and demand issues, but experts feel there is more going on with the recent plunge.  Take a look at these charts from the Financial Times website for the prices of corn and copper:

 

 

Copper is the metal most look to as a reliable barometer since it is essential for so many construction and manufacturing activities, but here in Australia it is the price of iron ore that most concerns us. Our country has benefited from the commodity boom in iron ore, but trading futures in that commodity is in its infancy.  You are aware the price of iron ore has dropped from around $180 to about $135, priced via producer customer negotiations.  The drop in iron ore prices is only one ripple in an ever worrisome global commodities pond. 

Originally intended as a protective hedge for a commodity producer and its end user, futures trading on commodity prices have become a barometer of macroeconomic health.  As such, macroeconomic concerns in times like these can radically distort the supply and demand fundamentals of individual commodities.

To complete the picture of the veritable collapse of the commodities complex we turn to the New York Board of Trade and the Continuous Commodities Index (CCI.)  This index includes 17 different equally weighted commodity futures from energies, metals, grains, livestocks, and softs.  The CCI is meant to provide a performance benchmark for investors and right now the picture is bleak.  Here is a 2012 chart for the CCI:

 

There is little more to be said except to discuss investing ideas for benefiting from the drop.  Speculating over the whys and wherefores often leads to more confusion than enlightenment.  One rational consideration is the rise of the US dollar, since commodities are priced in dollars.  But the question then becomes what is driving the US dollar?  You can find experts who argue that inflation concerns are driving the markets and others who claim it is deflation worries and some who actually propose deflation and inflation will arise simultaneously. 

As you know, experts can be wrong and often are.  A recent case to make the point is Australia’s GDP.  With Europe in a shambles and both the United States and China showing signs of slowing, experts predicted quarterly GDP growth of an anemic 0.6%.  As you already know, the actual growth was an astonishing 1.3% for Q1, which was 4.3% higher than 2011 Q1.  This represents the fastest growth rate in more than four years. 

While there is no doubt times are tough, there is also no doubt tough times present investing opportunities.  If macroeconomic concerns are driving down the prices of commodities and every other risk asset, does that equate with a slowing trend in demand for commodities?  To some it would appear that anyone with an ounce of common sense can look at the growing middle class in emerging market countries and see that demand will continue to grow, albeit at a slower pace.  So where then do we begin to look for investing opportunities?  We think there are three sectors to consider:

Diversified Miners

Agricultural Products

Gas Explorers

The Miners

Without a doubt, the Australia’s miners have suffered more from the commodities sell-off than any other sector.  Gold miners continue to underperform and the picture for even our biggest diversified miners is far from rosy.  At greatest risk are the pure play iron ore miners, especially the juniors who will have a challenge funding operations going forward.  Here is a table of Australia’s two largest diversified miners and two junior miners:

Company

Code

Mkt Cap

Share Price

52 Wk Lo

52 Wk Hi

P/E

Div Yld

ROE

BHP Billiton

BHP

$102,517M

$31.92

$30.71

$45

9.13

3.2%

38.32

Rio Tinto

RIO

$23,792M

$54.60

$52.83

$84.53

7.26

2.8%

29.6%

Mt Gibson Iron

MGX

$917M

$0.84

$0.82

$2.00

4.15

5.3%

19.8%

Gindalbie Metals

GLB

$511M

$0.41

$0.41

$0.87

2.5%

 

Noticeably absent from the table is Fortescue Metals (FMG) for two reasons.  The first is unlike BHP and RIO it does not provide some safety in diversification.  The second is it is a major target of short sellers.  As we will see in a moment, the two junior miners also come with high risk, but first let us begin with the safer plays.  Here is a one year share price movement chart for Australia’s biggest dogs in the sector, BHP and RIO:

 

BHP is now trading at around $32 a share, only slightly above its 52 week low of $30.71.  Investors have not seen a price this low since the company’s share price began its post-GFC recovery in the second quarter of 2009.  BHP has a P/E of 9.13, a dividend yield of 3.2%, and an ROE of 39.2%, all solid indicators for value investors. 

At around $54 per share for RIO – again close to its current 52 Week Low of $52.83 – you would have to go back to the third quarter of 2009 to find a price so low.  With a P/E of 7.26, a dividend yield of 2.8%, and an ROE of 29.2%, RIO should also be appealing to value investors.  However, could they be value traps?  How much further can they drop?

Obviously no one can say for sure but the sad truth is in a sentiment and news driven market, it is entirely possible.  On the afternoon of 13 June in the US investors reacted to news of rating agencies downgrading Spain’s credit rating and warning of more trouble ahead.  Predictably, US markets tumbled.  RIO and BHP might fall further, but with the current share prices reflecting roughly three year lows, do you really want to wait?

For whatever it is worth, the analyst community remains positive on both, and especially on RIO.  Since 13 February 2012, major brokerage firms BA-Merrill Lynch, UBS, Deutsche Bank, Macquarie, Citi, JP Morgan, RBS Australia, and Credit Suisse are all maintaining BUY, OUTPERFORM, or OVERWEIGHT ratings on RIO.  Opinions on BHP are similar, with both BA-Merrill Lynch and JP Morgan lowering price targets with NEUTRAL ratings.

By virtue of their sheer size and market share, BHP and RIO should weather any economic storm, as both have done in the past.  If you can weather the extreme volatility that is likely to remain a hallmark of share market investing for some time, both are worth a look.

The same cannot be said of the two junior miners in the table.  While BPH and RIO have dropped between 25 and 30% year over year, the two juniors are down 50%.  Here is their share price movement chart:

 

Although Mt. Gibson Iron has an attractive dividend yield, a low P/E, a YOY positive increase in operating cash flow, and low debt, this stock continues to hit new 52 week lows.  Their most recent rating from BA-Merrill Lynch is UNDERPERFORM with High Risk, while a few weeks prior Deutsche Bank rated the shares a BUY.

While Mt Gibson may be attractive to those with high risk tolerance, Gindalbie Metals is more a candidate for those who get a thrill from rolling the dice.  They have a debt to equity ratio (gearing) of 65.5% and long term debt of $361.7M with negative operating cash flow.  They have been surviving on financing and despite the anticipated difficulties of loans for small cap companies, analysts are still positive on GBG. From 27 January 2012 to 27 April 2012, Credit Suisse, UBS, BA-Merrill Lynch, JP Morgan, and RBS Australia all are maintaining BUY, OUTPERFORM, or OVEREIGHT ratings on the stock, but with a High Risk warning.

Agricultural Products

Considering the drop in soft commodities one would expert Australian agricultural shares to have suffered across the board, but this is not the case.  There is one standout.  Here is a table of four of Australia’s top agricultural products companies:

Company

Code

Mkt Cap

Share Price

52 Wk Lo

52 Wk Hi

P/E

Div Yld

ROE

Incitec Pivot

IPL

$4,398M

$2.70

$2.62

$4.13

9.43

4.2%

14.3%

Graincorp

GNC

$1,870M

$9.43

$6.74

$9.65

9.87

4.8%

12.1%

Nufarm

NUF

$1,256M

$4.79

$3.08

$5.74

11.18

6.5%

Australian Agriculture Company

AAC

$340M

$1.08

$1.02

$1.48

26.99

1.8%

 

On occasion, an agricultural company’s share price will move in seemingly perfect synchronization with the price of the commodity it produces.  While such a correlation is never a definitive indication of cause and effect, it nevertheless is fodder for investors on which to chew.  AAC gives us such a picture.  They are Australia’s largest cattle producer and their beef is exported internationally.  Between 2011 and 2012 the company is expected to more than double its NPAT – from $11.8M to 27.8M – and its earnings per share – from $0.04 to $0.089.  Here is their one year share price movement chart

 

Now let’s look at the price of cattle futures contracts from the Financial Times website

 

It now appears AAC’s share price is decelerating faster than cattle prices.  Analyst coverage is sparse but RBS Australia has a HOLD rating on the company, but that was based on higher cattle prices back in February 2012.  The company has negative cash flow and in 2011 relied on share issuance to fund operations.  Although the demand for beef products is expected to grow in emerging markets, there are better plays.  One of them is GNC (Graincorp.)

GNC does not produce grain, although it does buy and sell wheat through a subsidiary.  Its principal business is grain storage and handling.  We can see a correlation between GNC’s share price and the price of its principal grain – wheat.  Here is their one year price movement chart, followed by the one year chart for wheat futures:

 

 

Although the analyst community is lukewarm on GNC with only two recent BUYS along with an UNDERPERFORM and two HOLDS, this stock bears watching.  It is up about 15% year over year while the ASX 200 XJO index is down about 12% and it tripled its net operating cash flow from F 2010 to F 2011 – from approximately $100M to $300M.