Investing in resources

The following is the first of three excerpts from Resources Rock: How to Invest in the Next Global Boom in Natural Resources, by Malvin Spooner, founder and president of Toronto-based Mavrix Fund Management, and Pamela Clarke, a former correspondent with The Economist Intelligence Unit in Europe. The book is published by Insomniac Press and sells for C$21.95.

Think back — way back for some of you — to your first high school dance. Maybe the DJ played your favourite song, your partner was an incredible slow dancer, and you made plans to go out on a hot date in the future. Or maybe you spent the entire evening sitting on a bench, waiting for the moment when you’d be asked to dance instead of doing something to make it happen.

Investing in resources is a lot like that first dance. It can be nerve-wracking and stressful, but ultimately sweet, if you’re prepared to take some chances. Doing the research, then mustering the courage to make the investment can be as agonizing as that long, lonely walk across the dance floor. In both cases, you risk failure on a variety of fronts: you get turned down for the dance/the stock dives just after you buy it; your partner can’t dance/the market plateaus; you start to sweat uncontrollably/you panic and sell your shares as soon as they go up or down by 5%.

Most people won’t admit what went wrong if things don’t work out as they had planned. They’re quick to blame their friends or their advisor, or say the music or the market just wasn’t right. While nothing can reverse your experience at your first dance, it is time to rethink investing in resources.

– Why now? — Well, it’s not just in music that timing is everything. It’s also the case when it comes to investing. For years, the average prices of shares in resource sector stocks-from gold to diamonds to forest products-were at record low levels. Fraught with scandals such as the infamous Bre-X debacle, battered by international trade disputes, and smeared with the long-standing reputation of being populated by fly-by-night companies, the resource sector has not been able to pull out of its widespread slump in more than twenty years.

Unfortunately, people usually only feel comfortable investing when everything appears to be just perfect. Before they make a move, they want prices for commodities such as gold, metals or forest products to be strong, and companies to be profitable and have backing from a robust economy. They’re often sorely disappointed. If investors jump into the market when all the signs are positive, then the real gains have already been made and there is little, if any, room for serious profits to be had. It’s like asking someone to dance when they’re swaying slowly in somebody else’s arms. You’re a little late. Likewise, when the market is hot, it’s best to consider selling your shares, not buying them.

The ideal time for buying shares is just before all of the above factors are in place-before commodity prices are strong; before revenues are rising steadily; before the company makes a profit; and before the economy is back on its feet. Just like the best time to ask someone to dance is when they’re sitting alone, looking seriously bored. Enough of the analogies. Let’s address the most important timing factor of all: the industrial cycles of the resource sector.

– Cyclical industry — During the late 1980s and early 1990s, when Northern Telecom and American Barrick were performing fabulously both as businesses and as stock investments, the forest products industry was in the midst of one of its worse slumps ever. It looked as if things couldn’t get any worse for the sector, and that meant the time was right to begin buying stocks, that is, before the situation improved.

At the time, MacMillan Bloedel was one of the largest publicly traded Canadian paper and forest products companies. Everyone was talking about the horrific state of the economy in British Columbia, and specifically about the sorry state of the forest products industry in the beleaguered province. It was difficult for investment advisors to recommend their clients buy shares in MacMillan Bloedel. If they did, they’d be challenged by the tough conditions in the industry, and more than likely, their professional abilities would be questioned.

Wise advisors would retort, politely of course, that the rough markets and the wretched state of the market were why the stock was so cheap. As it was, people started buying shares in MacBlo several months later, paying a substantially higher price than if they had bought the shares when the earnings were at their lowest. One’s inclination may be to invest in a company when its earnings are up and its future looks bright, but at that point the lion’s share of the profits has already been made and it’s time to sell.

Later, after the forest products sector recovered, the president of MacBlo gave an update to investors in Toronto about the company’s financial forecast. He predicted steadily rising revenues, cash flow and earnings for the next several years, and then detailed how the company would be spending the windfall on building new mills and improving existing ones.

This is one of the many cases where senior management had forgot altogether that they work in a cyclical, not a growth, industry. It was definitely time to sell every stock you owned in the forest products industry and wait for the next buying opportunity — even though it might not occur for years. As mentioned before, the best time to buy shares is when the market seems to be the bleakest. Buy the stock when the company is losing a lot of money and sell the shares when they’re making more money than ever before.

– Understanding cycles — A big problem is that a committee usually runs research departments in investment firms. Advisors rely on the proprietary research published by investment analysts, and the last thing investment analysts want to do (well, at least the ones who want to keep their jobs) is recommend a sector that’s in the dumpster. Despite the fact that researchers may readily admit “off the record” that the time is right to buy the stocks, peer pressure and political risk make this admission untenable in a public forum.

How can researchers say to an army of investment advisors: “Hey, the commodity price is under extreme pressure because of a huge inventory overhang, demand for it is sucking wind, and the companies are all losing money. Therefore, I highly recommend that your clients buy it?” They can’t say that. So when it comes to investing in resources, the advisors have to go it alone.

That’s a shame. Although every resource (base metals, precious metals, forest products, petrochemicals and fertilizers) cycle is different and influenced by a plethora of variables, they all have one thing in common — the cycle. For example, there’s the hog cycle: when prices for pork bellies skyrocket, farmers have more profits to re-invest, so they produce more hogs. Then there’s a surplus of the critters, the price of pork bellies begins to plummet. Farmers then aren’t earning enough money to feed their hogs, so they cut back on production and another shortage ensues . . . and round and round it goes.

Most resource industries follow a similar pattern. When the market demand for a commodity is soft, prices fall and inventories rise. Companies aren’t profitable enough to increase production (by exploring for new mineral deposits, looking for oil and gas wells, developing coal mines, building new pulp and paper mills, etc.) as long as inventories remain high and prices for the commodity are low. Then when demand for the resources picks up, inventories are reduced, sometimes quite rapidly, depending on the commodity. However, prices don’t usually get higher until the inventory gets to the point where the threat of a chronic shortage is real. When it looks as if a shortage is imminent, the price for the commodity rises and suppliers start to earn some profits once again. But it can take quite a long time before businesses can respond by increasing p
roduction. After a discovery, it can take seven to 10 years to get a mine approved and built, which usually means missing a price cycle. Environmental hurdles make the lead times even longer today than has been the case in the past.