Make a mental note, dear reader. Next time I go on about China, buy iron ore!
In Tuesday’s Markets and Money, I commented on China’s latest stimulus measures, the financial risk building in the country, and the risks to Australia’s iron ore industry.
‘Australia was a prime beneficiary of China’s historic steel expansion. And while the iron ore majors will continue to feed China’s steel mills, they will do so at much lower levels of profitability once this stimulus starts to fade.’
Since writing that, the iron ore price has surged. It’s now trading at US$59.20 a tonne, up from around US$55 a tonne at the start of the week. Clearly, China’s stimulus spending is still in full swing.
But don’t let this distract you from the longer term dynamics. That is, China is churning out oceans full of unprofitable steel because it’s the only way it can keep economic growth from stalling.
To state the obvious, this is an unsustainable growth model.
Goldman Sachs knows it, too. From The Australian:
‘Goldman has lifted its three-month target to $US50 a tonne from $US45 a tonne previously, saying port stockpiles remain at historically low levels. The bank also lifted its six-month target to $US40, from $US35.
‘But Goldman still expects inventories to increase over the rest of the year and prices to fall to $US35 a tonne over the longer term.’
The ‘longer term’, of course, is a handy phrase that means ‘some unidentifiable point in the future’. It’s also a good term to use when you own a stock that is doing poorly. As in, ‘I’m underwater now, but in the longer term it should do OK’.
With that in mind, I think the ‘longer term’ outlook for iron ore miners is poor. But I wouldn’t bet against them just yet. The market is saying the short term outlook remains strong.
This throwaway phrase, ‘longer term’, got me thinking. It preys on the inherent uncertainty of investing. Successful investing is all about correctly anticipating the future. Nothing is ever certain. The future isn’t written, and so we look to it with hopes and fears, depending on our demeanour.
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The ‘longer term’ is a place where we hope (or fear) our future expectations are realised. We do this based on irrational fears or hopes, or with some analysis thrown in to help guide us. But either way, it’s a guess about the future.
For example, as an excellent article in today’s Financial Review points out, Mike Smith, former CEO of ANZ, had a massive punt on the banks’ future by engineering an ‘Asian Growth Strategy’. The gist of it was: ‘Let’s expand into Asia, and in the ‘longer term’ we’ll be a bigger/stronger/better bank’.
It sounded good, as many grand sweeping strategy proposals do. But it was flawed. Flawed for shareholders, that is; not for Smith himself, as the Financial Review reports:
‘For almost a decade under its swashbuckling chief executive, Mike Smith, ANZ Banking Group was the most enthusiastic proponent of Australian business engagement with Asia. Smith spent billions building a financial network from Jakarta to Chongqing designed to put the bank at the forefront of Asia’s historic growth spurt.
‘Smith, who was paid $88 million over eight years, was feted by politicians, lauded in the media and travelled the world mixing with the global financial elite. But ANZ’s Asian operations never delivered the profit growth he promised, and the bank’s new chief executive, Shayne Elliott, is pulling back from Asia, reining in its investment bank and toning down the combative internal culture that flourished under Smith.’
In other words, the promised ‘long term’ didn’t work out. Although it worked out very nicely for Smith. $88 million for a bungled strategy! $11 million per year!
That’s a perfect example of asymmetric risk right there.
That is, you have no downside regardless of the outcome. The grander the strategy, the greater the upside…especially if you know how to sell it to the Board. Smith was clearly a good salesman. His best product was himself.
I’m not saying companies shouldn’t have a crack, or that they shouldn’t have grand ambitions. But the rewards are grotesque for strategies that don’t pay off.
It didn’t take a genius to see that the Asian strategy would be a tough one. And I’m not just saying that in hindsight. I remember writing about it in a former role when it was first announced.
That is, ANZ’s strategy basically amounted to a shift of capital investment from a high returning, cosy oligopoly in Australia, into a lower return, competitive Asian region. There was a strong chance that ANZ’s profitability would decline.
And that’s exactly what happened. At the start of Smith’s tenure, ANZ generated a return on equity of 20%. In the 2016 financial year, forecasts suggest it will generate a return of just over 10%. That might not be all down to the Asian strategy. But it’s not a good look for a bloke who has literally made out like a bandit because of it.
It’s not all Smith’s fault, though. The board holds the ultimate responsibility for managing shareholder wealth, and they approved the strategy, and the billions of dollars in asset purchases, to execute it.
But now those involved are tight-lipped. According to the Financial Review article, the former chairman of ANZ, who hired Smith, didn’t want to comment on Smith’s remuneration. Nor did Margaret Jackson, who was head of the Human Resources Board Committee at the time.
But the most bizarre response goes to current Chairman, David Gonski. From the AFR article:
‘Asked if Smith was overpaid, Gonski, who became chairman in 2014, said: “That’s a strange question.” He said it was difficult to determine the value of any executive and people would have to make up their own minds. “The concept of saying ‘$86 million — he wasn’t worth it’ is quite a stretch,” Gonski said. “Was he worth $85.5 million? Was he worth $2.50?”’
That’s just weird.
ANZ is still paying Smith a lazy $250,000 a year, by the way. For what reason, we have no idea.
So here’s a parting tip for the kiddies out there. If you have a sizable ego, a thick skin, and not a small amount of chutzpah, get into banking. It’s the road to riches.
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