Survival of the Most Capital Efficient

Today we come to the difference between business and government. In business, if you don’t run your operation at a profit, you have to cut spending and become more efficient and productive with shareholder capital. In government, if you spend more money than you have, you just raise taxes on somebody else and ask them to sacrifice for the common good.

In business there is accountability, to the customer and the business owner (the shareholder). In government, there is bogus moral authority, where you justify your own incompetence by saying you’re working for a higher purpose. In business, profits come from voluntary trade. In government, revenues come from coercion and confiscation.

But you knew all that already! So let’s focus on what new BHP Billiton CEO Andrew Mackenzie is doing to make his poly-resource producer more capitally efficient. Mackenzie told the Wall Street Journal that BHP’s capital spending would be reduced ‘quite significantly’ under his leadership. It peaked at about $22 billion last year and will hit $18 billion this year.

Is that the decision of a company that’s planning for lower resources prices and lower Chinese demand? Well, we think so. But Mackenzie didn’t really say so. He said the company is after a ‘higher average return on smaller amounts of incremental investments…the prime drive is to get everyone working along the axis of productivity, running our operations more effectively, to increases margins and returns even in the absence of strong prices.

That last bit is exactly what you want to hear when you’re a shareholder. BHP Billiton wants to become a better user of capital, including returning it to shareholders if it can’t invest it profitably. But that doesn’t mean the company is getting out of the resource extraction business. After all, that IS its business. As long as there is civilisation, the world will need raw materials to build it.

Accordingly, Mackenzie says BHP will focus on four pillars: US oil and gas, Chilean copper, West Australian iron ore, and metallurgical coal (for steel making). A fifth pillar, pending final investment decision, is $10 billion in Canadian potash, which is really a play on 7 billion people needing food for the future.

In its own way, BHP comes closest to qualifying as a ‘fortress stock’. It’s like a small country. It’s geographically diverse, which spreads its country risk. It doesn’t rely on just one product (although its dependence on steel is a weakness, in our view). And as of yesterday, it recognises that if its shares are a kind of global currency, they’ll only retain value if the company manages its capital more efficiently.

Does it get a tick as a ‘fortress stock’  then? Not from us it doesn’t. But it’s no fault of the company’s management. It’s China’s fault.

-To be fair, it’s not REALLY China’s fault. The fault lies in trying to manage an economy with over a billion people in it as if it were a VCR to be programmed (apologies to younger readers who have no idea what a VCR is). China’s communists are trying to shift from investment led growth to consumption. This, by the way, is a reflection of the inefficient capital investment that takes place in a credit boom. But that’s neither here nor there for Australia.

For Australia, the issue is whether China’s growth rate is enough to drive profit growth for companies like BHP and the whole universe of mid-tier and junior stocks trundling along in its wake. Yesterday’s news wasn’t great. China isn’t growing as fast as economists hoped.

The April data suggests that domestic demand remains on the weak side, and by extension has also caused the softening in the service sector,’ wrote JP Morgan economist Haibin Zhu in a research note to clients. ‘Despite strong growth in real-estate investment and railway investment, manufacturing investment continued to slow down and the recovery in industry production is weaker than expected.

That’s two strikes. Domestic demand is weak but fixed asset investment is still growing. This means China’s growth model is still fundamentally (and perhaps catastrophically) unbalanced. You can’t blame the central planners for having a crack. But command economies always fail to allocate resources and produce real economic growth better than markets. This is why Greg Canavan reckons any positive noises about a China-led Aussie recovery are nothing more than a trap.

Stay tuned for more from Greg later today. In the meantime, if you’re feeling down that its deficits on out from here and higher taxes, take comfort. At least your government isn’t using the tax regulator to harass ‘enemies’, or spying on the media. Those are just two of the more recent scandals plaguing the second term of Barack Obama.

There seems to be a ‘second term’ curse in America. The Watergate burglaries took place before Richard Nixon was elected to a second term in 1972. But the hubris they revealed came into full bloom when Nixon began to govern. Reagan’s Iran Contra affair dogged his second term. And Bill Clinton spent most of his second term in front of a special prosecutor debating the niceties of English grammar and syntax with regard to sexual relations.

People in power become overconfident in their own abilities. This is especially dangerous since the people that tend to seek political power are psychopaths and narcissists to begin with. It will be interesting to see which institution survives the Credit Depression better: the nation state or the multinational corporation.

There will be more on multinational corporations as competitors to the nation state later this week from our technology analyst Sam Volkering. But today, let’s focus on the Credit Depression and what it means for Australian investors. Vern Gowdie, who we’re tentatively calling our ‘family wealth’ analyst, introduces you to the term ‘secular bear market’.

Dan Denning
for Markets and Money

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From the Archives…

The Higher the Market, the Harder the Fall
10-05-13 – Vern Gowdie

India’s Balance of Trade — a World out of Balance
9-05-13 – Greg Canavan

How the Dow is Just Wall Street’s Marketing Tool
8-05-13 ­– Dan Denning

Watch Out For When Australia’s Terms of Trade Goes Back to ‘Normal’
7-05-13 – Greg Canavan

The Greatest Wealth Transfer in History
6-05-13 – Bill Bonner

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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