Resource Companies

Investing Strategies Falling Knives
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The market is simply not valuing resource companies at reasonable levels given any plausible base case for how the world might play out, in our opinion. With oil prices up around 65% and natural gas prices up hundreds of percent since the beginning of 2020, Shell, a bellwether for the oil and gas industry, is more or less flat. With the movement in oil and gas prices, one would have expected Shell’s stock price to surge. It didn’t, however, leaving Shell at very attractive valuation levels. At commodity prices as of the end of the first quarter, Shell would be cranking out free cash flow yields of 22-23% for the next few years according to our models (see Exhibit 5).

And it’s not just fossil fuel companies. U.K. listed mining titan Glencore weighs in at free cash flow yields of around 24% over the next few years, while major U.S. fertilizer player Mosaic tilts the scales at almost 30%. If you’re willing to venture into smaller cap names and/or emerging markets, the disconnects can become even larger. To put these yields into perspective, the free cash flow yield of the S&P 500 was around 4% in 2021. Think about these numbers. If commodity prices were to stay at current levels, many of the largest commodity producers on the planet could pay down all their debt and buy back all their shares in just a few years and keep their billions and billions of dollars of cash flow for themselves.

The implication of these deeply discounted valuations is that investors don’t need commodity prices to continue to rise in order to expect strong returns. In fact, flat commodity prices would be brilliant. Stable commodity prices from this point would lead to hundreds of percent returns, in expectation, for many resource equities.

Given the disfavor the resources sector finds itself in, it’s hard to predict what, if anything, might bring valuations back to more “normal” levels. As an investor, however, it’s not clear that it matters all that much. If the market starts to appreciate the cash flows resource companies are kicking off and applies a higher multiple to them, investors will be rewarded with a quick win. However, in the absence of improved sentiment, the resources sector will continue to pile up the profits…and investors will continue to own their share of those profits. If valuations remain depressed, investors will benefit from a combination of high dividend yields, special dividends, share repurchases, and M&A activity. While the exact mechanism is unknown, if you invest in profitable businesses at attractive valuations, you will be rewarded.

https://mcusercontent.com/6750faf5c6091bc898da154ff/files/07…

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I don’t argue that there might be some bucks to be made in this upcoming cycle.
My gut feel is that you’re probably right.

The problem with resource companies is that they are, in general, poor businesses.
They have no return on assets, only return OF assets: most dig stuff up and sell it, the don’t make it.
There is no such thing as “copper production”, for example.
The consequence is that they are price takers. Their future fortunes are entirely out of their control.
And of course any given pile of assets eventually gets sold and runs down.

If you think you can predict commodity prices better than the rest of the world, and have good reason to believe that, then there is money to be made.
But I don’t fall in that category, and (perhaps more importantly) I know it.
I’ll go elsewhere, where the hunting is easier.

Give me a nice high ROE firm without undue leverage, at a reasonable price, and a lasting business model.
I’m fallible at identifying “undue” “reasonable” and “lasting”, but getting those roughly right is much easier than predicting commodity prices more accurately than the median investor does.
I’d take Intel before Glencore.
Not that I love Intel, it’s just an example.

Jim

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I believe the author was making the case that resource companies were better inflation hedges than gold or TIPS. So they would be candidates for the portion of your portfolio traditionally dedicated to gold or TIPS.

With resource companies the biggest question is how long the boom time will last and will they be disciplined in use of the prodigious cash flows. Will it be different this time?

Your example of Intel is interesting. Intel is the cosine wave to the resource companies sine wave when it comes to capital spending. Intel spent the last decade “returning” a good chunk of its cash flow to shareholders, while its competitors caught up and surged ahead. Now it is boosting capital spending and R&D in lower margin businesses like foundry. So how much lower will its ROE be a decade from now? Intel looks like the marathon runner, leading early on, now just entering the stadium parking lot while TSMC and Samsung are already in the stadium.

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Your example of Intel is interesting. Intel is the cosine wave to the resource companies sine wave
when it comes to capital spending. Intel spent the last decade “returning” a good chunk of its cash
flow to shareholders, while its competitors caught up and surged ahead. Now it is boosting capital
spending and R&D in lower margin businesses like foundry. So how much lower will its ROE be a decade
from now? Intel looks like the marathon runner, leading early on, now just entering the stadium
parking lot while TSMC and Samsung are already in the stadium.

[reminder that I am not touting Intel]

I guess it depends a lot on whether the more reasonable view is the first part of that quote or the last.
If it’s a cyclical problem, then they’re probably a great deal.
If the current popular narrative is true, that they’re irretrievably behind technologically and going to stay that way, then it’s not a good idea to back a loser.

They had the best manufacturing technology in the world for 25 years, so I think they probably learned something that stuck.
I have no very strong view, other than I think that the current “buggy whip” narrative is probably less than 100% true.
I think it more likely than not that they’ll be making pretty good money for many years to come.

TSMC is a formidable beast, to be sure. Too bad about the geopolitical risk.
Ironically, one of the material motivations for China to invade Taiwan is to get hold of TSMC.

Jim

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They had the best manufacturing technology in the world for 25 years, so I think they probably learned something that stuck.
I have no very strong view, other than I think that the current “buggy whip” narrative is probably less than 100% true.
I think it more likely than not that they’ll be making pretty good money for many years to come.

This narrative reminds of the rejection of MSFT when they were stagnated in the $20s for years. They were a cash cow but everyone saw a cigar butt. I think we’re on the cusp of an onshoring trend, and semiconductor manufacturing is a critical national security industry. Are there risks? Sure. But the reward is tremendous and the risks are that your money is stagnant for some time.

I’m a buyer.

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“Shell, a bellwether for the oil and gas industry, is more or less flat”

It’s up ~40% YTD, far from flat

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The relatively low valuations of such resource companies despite their prolific cash generation is similar to how tobacco companies are valued.

And yet they’ve produced impressive TSRs over the last 10 years
https://fingfx.thomsonreuters.com/gfx/breakingviews/1/494/60…

After all, the bulk of market volume is from so-called ‘smart money’ institutional investors, who are under increasing pressure to divest anything which doesn’t pass the ESG smell test. Never mind that the definition of what makes a good ESG company is mostly up to whoever you ask.

Just as they have had to abandon tobacco, they are being forced to dump resources.

Which leaves us ‘dumb money’ types with a bunch of high yielding but inexorably depleting assets to pick from, until the inevitable next resources crunch juices them through the next cycle.

‘if you invest in profitable businesses at attractive valuations, you will be rewarded.’

Only if there is a reasonable prospect of those ‘attractive’ valuations attracting enough new money to jack them up some time in the near future

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