Australian Resources Boom: Making Profits While Markets Fall

What does the drama in US markets mean for Australia? For one, borrowing costs are going to go up, both for individuals and corporations. No more easy money. Australia benefited from the global credit boom as much as anyone. It will now suffer along with everyone as credit is harder to come by.

But what of the resource boom? Is it over? We’ll share with you what we wrote this morning to subscribers of our paid research service Outstanding Investments.

All of our share tips are based on our view that we’re in a long-term resource bull market. This bull market is driven by industrial growth in China and the Far East and is what drives the earnings growth of the shares we’ve tipped. That fundamental strategy remains the same this week. But is it sound?

One school of thought is that a global credit crunch hurts Aussie stocks in two ways. First, a credit crunch in America means lower retail spending, which means reduced production of finished goods in China, which means reduced demand for Australian raw materials, which means lower resource prices, lower resource earnings and lower stock prices for the shares we’ve tipped.

The second way the credit crunch hurts Aussie stocks is that it reduces the flow of global investment capital to the local market. This capital from foreign institutional investors has found its way into Aussie shares, a popular way of riding the resource boom from Europe and North America.

This week’s events may result in reduced foreign buying of Aussie resource shares. But they will not, in our opinion, derail the long-term correlation between Australian resource shares and Asia’s growth. That relationship should benefit Aussie resource shares for years to come.

But what about the return of volatility? As the markets re-price risk and become more conservative, how can we go forward without taking large losses? Our strategy will focus, as it always does, on three factors:

1. Net tangible assets and a quality resource base. Volatile commodity prices may make it difficult to value the reserves and resources of some resource shares. But this simply makes it important to focus on those companies with quality assets and projects that can be brought into production without cost blowouts.

2. Cash and low debt/equity levels. The market will probably place a premium on firms with lots of cash and very little debt. This means they can survive commodity price volatility and not see cash-flow disrupted by higher borrowing costs.

3. Balance sheet transparency. The easier it is to see what a company owns and what it owes, the easier it is to value it. Financial stocks will continue to suffer because of the many unknowns surrounding the ownership and price of collateralised debt and mortgage obligations. Resource companies are much easier to value. That should be a benefit.

There are other factors in support of resource shares. Cashed-up sovereign wealth funds (not least Australia’s own Future Fund) may see this correction (or further corrections) as an opportunity to acquire ownership in firms with valuable strategic natural resources—on the cheap. It’s not exactly a fire sale, but many quality mineral and energy assets have been deeply discounted this week. Long-term strategists view that as an excellent opportunity, and so do we.

The trouble with the market right now is not the return of risk but the rise of uncertainty. There are a large number of known unknowns (groups that own asset-backed securities and bonds but don’t know what the market value of those assets or bonds is), and a large number of unknown unknowns (the unanticipated economic affects of a large contraction in global credit markets).

Or, if you prefer, it’s a matter of risk (what we think we know, but probably don’t) and uncertainty (what we definitely can’t know). Traditional financial models of risk – like the probability that a huge chunk of American homeowners will default on their mortgages and thereby cause global distress – work best when the probabilities of something are known, even if the definite outcome is not.

When you flip a coin, there’s a 50/50 chance you’ll guess correctly whether its heads or tails. The probability is the same every time you flip the coin. Flip it 50 times, and the probability is you’ll get more or less a 50-50 outcome. Even though you can’t know each time what the result will be, the distribution of outcomes is something you model mathematically.

Wall Street is in love with risk models that believe a world full of variables is reducible to probabilities that can be figured in equations. But these risk models aren’t really risk models because they underestimate the probability of something catastrophic happening. The models don’t account for outcomes which are more statistically probable that a mathematician would like to believe.

We stand today on the edge of uncertainty. Operating under conditions of uncertainty, you don’t know what the probabilities or the outcomes are. Spreadsheets are of no use. And even past experience can’t tell you what will happen with any certainty.

There is a positive aspect to this element of uncertainty. If you anchor your investments in what has generally worked in the past (lots of cash, low debt, strong underlying economic demand), you improve your chances of doing well over the long term.

Dan Denning
Markets and Money

Dan Denning
Dan Denning examines the geopolitical and economic events that can affect your investments domestically. He raises the questions you need to answer, in order to survive financially in these turbulent times.

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