Paradice's 3 preferred materials exposures and 1 sector to avoid
In a normal cycle, high prices for commodities from high demand would lead to increased supply and finally a drop in prices – but these are far from normal times.
According to Tom Richardson, Lead Portfolio Manager of Paradice Investment Management's Equity Alpha Plus Fund, factors like the energy transition, underinvestment in production and ongoing demand from China may see prices rise further, or at least stay higher for longer. He is the first to say this might be a dangerous view and investors should be selective about their commodities investments.
Given short-selling is a part of the strategy for the Equity Alpha Plus Fund, it is not surprising that Richardson gravitates towards stock and sector risks like this where careful selection and the right application of research could make a difference.
“We're absolutely willing to take on commodity-specific risk because we have very detailed supply demand forecasts for all these commodities, and ultimately, it's our job to work out whether the commodities are going up or down.”
Livewire’s James Marlay spoke with Tom Richardson about his outlook for commodities and a ranking of the top three opportunities for the commodities market, along with stocks supporting these opportunities.
They also discussed how Paradice finds opportunities by identifying short-term behaviour and the four factor model that consistently delivers outperformance.
- 0:52 - Why short-term thinking in markets is an opportunity
- 3:20 - Rising real yields and the impact on investors
- 6:20 - Paradice’s four factor portfolio construction model
- 7:47 - Using stock-specific risk and an example
- 10:54 - The continued opportunities in commodities and materials
- 15:35 - Tom’s top three commodities opportunities and stocks
To access the interview, please click on the player or read an edited transcript below.
Can you explain how you use short-term thinking to identify investment opportunities?
It may not be a surprise that, as an active manager, we have a belief that markets are inefficient and a lot of those inefficiencies come down to short-term thinking or emotional investors and where they extrapolate the current environment for too long and don't take a step back. I think over the last two years, it's safe to say that we've seen that in spades.
Now I've got a chart here that shows the consumer goods spending by the U.S. Consumer. The categories within here are home furnishing, electronic car accessories - basically think anything that turned up in a cardboard box at your front doorstep. This is a 30 year chart, and the acceleration is absolutely phenomenal now.
This may not be a surprise to those who are very aware of the services to goods shift when we were all sitting at home. But what was more surprising to us? We did this analysis at the start of the year and looked at all the companies that are exposed to this thematic now. The consensus forecast for these companies had no normalisation. I look at that chart and there’s a good chance it goes under the dotted line because it’s almost impossible to forecast what the back of the demand curve will be when there’s been such a pull forward. What was remarkable was the consensus forecast that this was the new normal. These companies have grown by 50% and they could continue to grow at 10 to 20%. We're in a bit of a reckoning period. Some of these stocks are starting to realise that, but unfortunately, it's not an opportunity sector for us here. It’s one that we're very cautious on, and I think it highlights why we think markets can be inefficient. The takeaway from this chart is really that, people extrapolate what's been the recent past way into the future. The reality is that we experienced such an extreme that there's a reversion to the mean, and it takes a while for markets to adjust in prices to correct.
Can you explain the impact of rising real yields and why it matters for investors?
It’s a regression model of the US market over the last 50 years from Citigroup. What you can see on one axis is the forward multiple of the market and the other has US real yield at that time. It shows that when money is free, the markets become expensive and when there is a cost of capital, markets get cheaper. We’re in the transition at the moment. In fact, we’ve had the fastest adjustment in the cost of capital in 30 years. This note actually came out on the 29th of April and at that point, the US market was trading on 19x PE and the real yield was still negative. It was about -0.2 and central banks are catching up and they’re pushing interest rates much higher. In fact, inflation expectations have come back a little bit in the last six weeks. That’s meant the real yield has gone to about 60.7 and it adjusts the normal interest rate for an expected rate of inflation. Since that period, the market has fallen 15%. It’s been a very dramatic adjustment but if you look at the regression over 50 years of data, it’s as you would expect.
The real yield change has probably happened quicker than we would have expected and likely quicker than many in the market expected. In terms of the rating of the market in response to that real yield, it looks pretty fair.
How much more normalisation or correction can we expect?
The first belief is that we're not going back to negative real rates for a long time, so this is the new norm. I don't expect some miraculous bounce in terms of whether real interest rates need to be 0.5-0.7% to slow down the cycle and ultimately, cool it. Inflation is very hard and not something I’ll get into but in terms of positioning, the most extreme evidence is in terms of growth and duration assets and their multiples come down the most in response. From a positioning perspective, this means we’re positioning in more short duration assets where you’re getting the cashflow up front.
I would be very cautious on high growth, high PE businesses unless you’re very very confident that the growth will be there on a 5-10 year basis.
Can you explain your four factor portfolio construction process?
It’s a pretty simple model. We just look at the PE, the growth, the balance sheet and ultimately the free cashflow yield. Four very simple metrics. It’s also a very constructive formula when you're looking at a stock investment. It takes out the story around the stock and looks purely at the numbers.
Where do we see opportunities based on the numbers and the growth that we can see within the stock? It’s still difficult to find a lot of ideas in the market when we look through those factors. The sector that we’re gravitating towards is the energy sector, they're looking cheap. The stocks have de-rated on the expectation of peak commodity pricing, which we can touch on later.
They're growing because obviously the commodity prices are growing. But they also have development assets, which is growing production, the balance sheets are de-gearing very quickly as they’re spewing off a lot of cash within this environment. So we're very aware of the cyclical risk that we're taking, but there's a lot of supply changes within that sector, which give us comfort that these prices are a little bit more sustainable than they have in the past.
Energy ultimately ticks those boxes for us, and that's the sector that we’re overweight.
People tend to avoid stock-specific risk but this is one you gravitate towards. What is an example of a stock-specific risk and why do you like it?
Well, in terms of stock specific risk, what we're trying to do is here. The macro is very difficult, very hard to predict. So anywhere where we can put in stock-specific risk over just a generic factor risk, that's good for our portfolio.
The one caveat to that would be commodity-specific risk.
We're absolutely willing to take on commodity-specific risk because we have very detailed supply demand forecasts for all these commodities, and ultimately, it's our job to work out whether the commodities are going up or down.
It's interesting when you think about the growth names we touched on earlier. A year ago, it was all about these companies that were changing the world and amazing stories. Whereas this year, it almost feels as though they are dependent on inflation and interest rates falling for those stocks to work again.
We don't want to tie ourselves to one factor that's exogenous that we can't control. We want to put stock-specific risk in the portfolio where we can, and one of the stocks in our portfolio that we think can work is Qantas (ASX code: QAN).
It’s for the reason I mentioned that we're very constructive on the energy thematic as I touched on earlier. We think that oil prices are going to go higher, which is a huge headwind for Qantas and the airline industry in itself. But we still think that Qantas is actually good value and the reason is that because capacity management ultimately will dictate returns for that industry. If you think about the domestic position, they are very, very well positioned, especially with Bain being the owner of Virgin (ASX:VAH) now. They're already managing capacity and internationally, they're getting steamrolled in terms of demand and most of the routes are still only at 50-60% capacity because they can't put it on and so prices are going high. They have to do that to recover oil and their costs. Then the last point with Qantas is they have the frequent flyer business and it's been a bit of duck underwater because, while they've had planes grounded with covid shutdowns, that business has ticked along really nicely. They're actually targeting $500-600 million of earnings in FY24 now. The street expectations are well below that.
If they can achieve that, that's going to be 30 to 40% of the group earnings coming from a very capital-like growing business which ultimately deserves a higher multiple. So despite the fact that we think energy is constructive, we think that the Qantas can work in this environment.
How much of that inflationary pressure can airlines pass through to the consumer?
Well, we're about to find out. If you’ve looked at a business class ticket to the US, they are very high. The demand in elasticity that they're seeing at the moment is very small. That is because this spend is the complete reverse of that chart that we put up in topic one. The goods you're spending a lot on - you might buy a few less shoes, but you might have to buy a few more tickets. So in the next year or two, we think that, demand and elasticity is going to be very low. It's going to be a challenge for the industry to pass through these costs, but ultimately we think that people are willing to do it because people want to get on planes again.
Can you talk me through your thesis on the materials sector and why you like it?
We think about the prices are high for a lot of commodities at the moment, and everyone is familiar with that. But commodity prices don't go down just by themselves. They will either go down because supply rises or demand falls. If we touch on the first topic, we've actually got a chart which shows the investment within the basic resources as a percentage of GDP versus the return on those assets.
As prices go up, investment response supply follows and prices come down, you get a normal cycle. What's really interesting in this cycle is that there's been minimal investment for a decade, absolute under-investment almost across the board in commodity land, and so you can see that the return on assets are up almost to where they were back in 2007. There has been no response in terms of supply. Now the reason for that is if you go back to 2012-14, the amount of capital destruction from the mining companies and the energy companies was obscene, absolutely eye-watering. Everyone put their wallets back in their pockets for a while, and they only get them out to give it to shareholders. So that is why this cycle might last a little bit longer than people expect is there is just no supply response.
Then if you think about demand now, clearly we're going into a slowing demand environment which will have an impact on commodities, and that's what we've been seeing over the last five months.
There's two key elements that are different this time.
- The energy transition is commodity-intensive almost across the board. It's just incremental for some and large for others. But any way you look at it, the energy transition is going to require more commodities.
- The second element is that China is the absolute biggest behemoth. It's 50% of most commodity demand and they've been shot down. They have not pulled through as much as they would normally in the first half of this year. If they can fire up the economy in the second half, we could be in for a bit of a surprise here. Commodity prices could move higher.
As we go into a slowing demand environment, which we absolutely are, it is time to be a little bit more selective in your commodity exposure.
The two areas that we're focused in terms of our commodity exposure from here are where you have a structural demand story where you really are underwritten on that demand supply, even if we were going to a sliding demand environment; or you have a supply story which is so compelling that it's hard to see, even with the slowing demand, getting back to some sort of cost support because the supply is just not going to be there.
Ideally, we can find commodities that have both of those boxes ticked.
Materials are the second-best performing sector behind energy. You view a lot of materials stocks as cheap, even with some, like lithium that have tripled in price. Can you give me more detail on this?
Your investors are probably aware of the old adage, which is sell mining companies when they're cheap and buy them when they're expensive. As we’re seen on the chart showing the cycle in terms of return on assets, this is a highly cyclical sector. What happens is that when these resource companies make a lot of money there, PEs become cheap, and that is in response to high commodity prices. Now, generally, that is the assigned time to sell the sector.
When they're not making any money, that is absolutely time to buy the sector as you can see from the return on assets chart. Inevitably, supply will reduce, demand will pick up and you'll make money again. Generally speaking, you want to be buying these stocks when they've got high PEs and selling when they're low.
This time, we think the stocks are on low multiples, so they are cheap. But we think, for the reasons that I just articulated, that commodity prices will stay higher for longer than a normal cycle. Dangerous to say that and with a slowing demand backdrop, we want to be careful. We’re watching demand very carefully. Any commodity that we think has incremental supply, we're getting more cautious on, or any commodity that we think was a bit of a covid beneficiary and benefitted from stimulus that is coming out. We're definitely being more selective on our commodity exposures this year versus last year.
Can you rank the three commodities you think have the most interesting outlook and pick a high conviction idea in each?
We'll kick it off with number three and it’s rare earths and more specifically, NDPR (neodymium-praseodymium) which is a key ingredient for high strength magnets.
Now, this is a key ingredient for electric vehicles and wind turbines. It's really enabling the energy transition. So the demand growth is probably looking at 15 to 20% for the next 3 to 5 years by our calculation. It ticks the box that I touched on earlier around structural demand stories. Now it also ticks the box of no real supply.
China controls 60% of the resource, they control 90% of the process. Everyone has just woken up to the fact that this is probably a little bit of supply risk and we need to get out supply chains outside of China where we can. That's ultimately led to the Australian government looking to fund a refinery here in Australia from Iluka (ASX: ILU) and the U.S. Government doing similarly with Lynas (ASX: LYC). The other thing is that the commodity price has gone up around three times so it's definitely had a good run. In terms of the next wave of projects, they need 120 to get up. In fact, they're not getting up. There's probably five or six railroad companies in our market with very small market caps struggling to get funding, struggling to get up so the commodity price signals are not quite there. It’s very highly likely or possible in our explanation that the commodity price will move higher to ultimately bring those commodity incentivised to incentivise that supplier. And so ultimately, we think Lynas is very well positioned with the plant here, and they’re building in Australia and Malaysia.
Number two is the fertiliser market. Again, we're looking for supply and demand balances that looked really strong and specifically with fertilisers. We're looking at the phosphate market. There’s been no investment in the phosphate market in a decade.
There was oversupply going back and processes are in doldrums only up until three years ago. The Russian invasion of Ukraine has made that situation very interesting. Ultimately, it's impacting gas markets, there’s the ammonia impact and then, also the cost. Pressure on phosphate producers is rising significantly as well, so there's not a lot of spare phosphate production around. Then if you think about the demand, obviously you're underwritten from a soft commodity perspective, which is very high but incrementally phosphate is going into LFP (lithium ferrophosphate) batteries. You basically have two different types of batteries for electric vehicles and LFP is one of them. It's only a small amount of phosphate goes into the battery, very small. But when you're talking millions and millions of vehicles, it’s starting to add up. China exports about eight million tonnes of phosphates each year, and the rest of the world is reliant upon that material. Now they are pivoting that production to electric vehicles, obviously, rather than exporting phosphates.
Why don't we put into electric picture with higher manufacturing? And the estimation is probably 2-3 million tonnes will come out over the next 2-3 years of that. At a time when demand is growing, there is no supply. It's very hard to see the phosphate market going down. Incitec Pivot (ASX: IPL) is a big, broad business. They do have one phosphate plant up in Queensland, Phosphate Hill. It's under maintenance at the moment, so touch wood, it starts up okay, but they're very well positioned to make a lot of money out of that plant for the next 3-5 years in our view. Phosphate is a hard commodity to locate. It’s about phosphate rock. That’s why Incitex is very well positioned because they have the rock. There's also non-integrated producers who have to buy the rock, and the rock price has gone up a lot as well. So it's not just about the phosphate rock. It's about the gas and the sulphur as well. You’ve got to have a bit of the triple threat, and they're very lucky with their position at the moment.
Number one is natural gas, LNG (liquified natural gas) markets. There is such a huge supply challenge within this market for the next five years, in our opinion, and it all stems back to what we talked about 2012-2014, the LNG investment.
We've seen it in Australia, probably more than anywhere. The amount of money that was torched, there's been no investment. No one's looked for it. No one's built anything for the last six years, and so there's been no supply growth. And now, obviously what's happened with the Russian invasion of Ukraine has meant that Europe is incredibly short gas. Everyone is familiar with that, and the supply challenge is enormous. In the backdrop, you've also got ex-China Asia growing. The energy market still probably needs another 70 million tonnes over the next four years. There are just no projects ready, and so Woodside (ASX: WDS), with the merger of the BHP (ASX: BHP) Petroleum assets, is incredibly well placed. They've got on contracted molecules in very low risk jurisdictions. It is absolutely what the world needs for the energy transition, which is obviously taking longer than we may have expected a few years ago. LNG looks like a very good place to be parking some money for next 3-5 years in our view.
Tom, thanks very much for coming in today. I really appreciate you bring along these charts. Hopefully for you viewers, you've learned something new.
About Paradice Investment Management
At Paradice, their objective is to deliver superior risk-adjusted returns and capital protection over the medium to long term. They employ exceptional investment professionals with a proven track record. By combining extensive in-house research with a disciplined approach to portfolio construction they continue to deliver on their core promise. Click here to find out more.
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