Materials weight watch
Rob McConnachie
View from the Street, Financial Post
Monday, September 19, 2005
It is a market completely dominated by commodities with the materials sectors, including energy, accounting for over 40% of the S&P/TSX composite index.
It will only get worse when trusts are added, about half of which are oil and gas.
Not surprisingly, many investors are fretting away on whether to be over or underweight these sectors that the gnomes who designed the index have determined should comprise such a large portion of "the market." Seeking direction from the "experts" on an appropriate weighting may not be very helpful. It's not that long ago we were listening to them explain how the new economy would spell the decline of demand for raw materials.
It was the scarcity of bandwidth that we should be concerned about. The March, 1999, issue of The Economist warned "US$10 [oil per barrel] might actually be too optimistic. We may be heading for US$5." It was "different this time," we all heard.
Now that commodity prices are high, the experts are predicting even higher prices. According to Jeff Rubin of CIBC, oil prices are "expected to reach or exceed US$100 per barrel by the fourth quarter of (2007)."
I am decidedly underweight materials, including energy. As a manager of both institutional and private client assets, I don't believe it is prudent to invest 40% of my client's retirement money into industries with little pricing power that typically return very little cash flow to investors. My clients need strong cash flows and stability.
Relying on meaningful shareholder distributions from the materials sector to fund retirement is imprudent. Cash flows are all too often retained within companies in this sector as they scramble to replace reserves or invest in additional capital projects. There rarely seems to be sufficient free cash flow to reward the risk-takers who own their shares. And, especially in the metals sector, even in times of stable prices some of the best-known companies have not earned their cost of capital.
Moreover, history has shown the unpredictable nature of future commodity prices. Worse still, (as the accompanying chart shows) if you adjust for inflation then commodity prices have been in a long-term downward trend.
It happens time after time. A commodity shortage attracts new capital and new technology, leading to expanding supply. High prices also eventually have an impact on demand and increase the viability of substitutes. Basing an investment strategy for retirement assets on commodity price speculation would not allow our clients the good nights sleep they hire us for.
Don't be misled. I do have investments in some materials companies. Within the sector I am heavily exposed to companies operating in the Alberta oilsands. Although I don't forecast the price of commodities, I do know oil is non-renewable, and the oilsands mines have very long reserve lives. It seems to me there is likely to be more cash flow available for my clients to retire on when the reserves are expected to last many decades, even with a substantial drop in price.
I also have a meaningful position in a cement company. Again, it has a long-term supply of a material, in this case aggregate. A secure long-term supply allows for more of current cash flow to be paid to investors, rather than retained in order to replace current production.
The cement industry also has substantial barriers to entry as the company itself discovered after a five-year permitting process for a new plant was recently rejected by the local authorities. Moreover, the economics of high transportation costs give its numerous strategic locations some pricing power.
So where will the price of commodities go from current levels? I'll leave that one for the experts. I can't forecast commodities. I don't understand how you can do it with any accuracy and I don't believe there is anybody that really can. That's not a good basis upon which to make long-term investments.
In the meantime, I will continue to look for reasonably priced businesses that make a high return on invested capital in most market cycles, and are run by management with high integrity.
Industry weightings will be more guided by what is suitable for my clients rather than what the market index dictates, because, as Stevie Wonder said, "If you believe in things you don't understand, then you suffer..."
Rob McConnachie is a Portfolio Manager at Dixon Mitchell Investment Counsel Inc. View from the Street runs in the Financial Post on Mondays, providing a podium for select investment industry professionals to express opinions.