Assessing management is a vital skill if you want to find great companies.
By Owen Richards, author
Someone once told me that the thing he liked in company annual reports was the photographs of the board members and the management team. This enabled him "to check how dorky they look". I'm not sure whether this is particularly helpful in share selections for investment purposes, but in an oft-quoted statement by the US investor Warren Buffett, his preference is always to choose companies that he understands, have an able and honest management, and are being offered at a reasonable price.
It should be fairly simple to meet his first criterion and also to make a judgement on whether the price is reasonable. However, it is more difficult to assess management, although a starting point is to look at the quantitative aspects of their effectiveness from their financial reports. Probably the most common measurements of how well a company is being run is to determine its return on equity (ROE), return on assets (ROA) and earnings per share (EPS) growth.
These are simple ratios to calculate, and then relate them to the company's market capitalisation and the industry it is in. In all cases, it is important to establish the ratios first and then, as far as possible, compare them with companies in the same industry and which have a similar capitalisation.
Some suggested ratios for a healthy, well-run company are:
ROE of greater than 10 per cent and rising
ROA of greater than 15 per cent and rising
EPS growth of about 10 per cent over the past year and rising for the past 18 months.
Low-capitalisation companies, such as software companies and consultancy firms, which are well run, will probably have much higher ratios.
Figures may not lie, but …
We should now be familiar with the saying "figures don't lie, but liars can figure". Investors should always treat any numerical representation with some caution. Although ROE is probably the most popular quantitative measure of management effectiveness, this ratio (like any other) can be manipulated. Companies can artificially maintain a healthy ROE by increasing debt leverage and using share buybacks funded through accumulated cash, to mask a deteriorating performance.
No single metric is ever perfect and different approaches are always appropriate to get a more accurate representation of management performance.
It is a more complex task to make a qualitative assessment of management - that it meets Buffett's "able and honest" test - but essentially it is critical that management's interests are aligned with those of its investors. There is, at present, substantial general interest in the resignation from a famous US investment bank by a senior executive after 12 years with the company. What is different in this case is that his letter of resignation was effectively printed in the New York Times.
The executive describes the culture of the company as "toxic and destructive" and lays the blame for this on the current CEO and president, who he says have "lost hold of the firm's culture on their watch". He cites their major failing as essentially focusing only on "...how can we make the most possible money?" Some commentators have expressed surprise and said that this is what an investment bank is supposed to do.
And, of course, this is true. But as the executive points out, this cannot be at the expense of their clients whom, as well as being referred to internally as "muppets", are allegedly being sold expensive products that are not appropriate to their needs. Nor is this fair to the shareholders, who must see the company's value deteriorate over time as the client base inevitably declines.
Things to look for
There is no doubt that a company's board acting through the company's management (collectively, "management") will largely determine the shared attitudes and beliefs of the company and how well this aligns with the interests of all its stakeholders and especially its shareholders. Although there is no fixed template, there are some characteristics that investors can look to for guidance on how well they can assess their interests will be best served.
Good management should have substantial ownership in the company, often referred to as having "skin in the game", through shareholdings or options. This indicates the belief that there is no better alternative for their money, and should provide some security for investors in knowing that management is unlikely to perform foolishly in the long term with their own wealth at stake.
Keep an eye on major share purchases or sales by board members. If a number are bailing out of the company within a reasonably close timeframe, look for reasons why; but always be mindful that individuals have to buy houses, educate children and diversify their own holdings.
Look for management that acts as a steward of your interests. The worth of management is not necessarily related to a strong performance within a short time, and a good share price does not necessarily indicate a high-quality company. You want people who can invest in projects and activities that create value for the shareholders in the longer term. Still, where the chairman or CEO of a company is also the major shareholder, there is always a possibility that deals may be done that are more in their personal interest than the company's.
Excellent management surely increases investors' value, but excellence must be paid for. You don't want management that unreasonably increases their bonuses at the expense of the shareholders, or pays their top people outrageous salaries. Diverse industries offer diverse amounts, but you should look for companies that reward its officials with compensations that roughly match similar industries.
Wanted: reasons, not excuses
Honesty takes a number of forms. What you want in a CEO is someone who is not afraid to admit they have made mistakes. If something like an earnings disappointment occurs, you deserve an honest explanation as to why and what is planned to overcome it. Too many companies provide only excuses for poor performance and blame external factors, such as the government or the economy. It can also be useful to check the tenure of management. Look for rock-solid management that has been with the company for years.
You should read the section on management's discussions and analysis in the past couple of annual reports and make an assessment of how thoroughly they follow through on their planning and promises. You may find that many of the plans of management were never implemented.
You want a management that is consistent in words and actions. Look at the company's mission statement and its effectiveness. Good mission statements create efficient managements and usually good returns for shareholders. If all you read is corporate jargon and buzz words, management is not being honest with you.
In many ways, if you are interested in a company where the directors are people of known probity and the company is generally acknowledged as well run, your requirement for assessment may be minimal. If business scandal has touched any one of them, however, exercise caution. It is rare for a leopard to change its spots.
Viewing the financial statements every six months is essential, although they do not always tell the whole story. In the final analysis, companies are staffed and run by people, and it is a wise investor who checks as best as possible the people who set out these financial statements.
About the author
Owen Richards has been a trader for some years and is a contributor to local and overseas trading magazines. He has written this story on behalf of the Australian Investors Association, an independent, non-profit organisation aimed at helping its members become more successful long-term investors.
From ASX
Don't miss ASX's new Corporate Profile series, which provides a short video interview to help companies inform investors. Many of these profiles are for small and medium-size resource companies. Each three-minute video usually features a chief executive who explains their background and experience, and gives an overview of their company's business and growth plans. This helps investors put a "face" to companies and learn more about those running the company on a day-to-day basis, in a simple, user-friendly format.
© Copyright 2012 ASX Limited ABN 98 008 624 691. All rights reserved 2012.
A lot has been said and written about the delisting prospects for Indian arms of various MNCs listed on the Indian bourses, for 2 years now... and stocks have got re-rated in expectancy of such moves. Therefore, rather than re-iterating the broad rationale, which has already been over-emphasized by media and brokerages alike, I'd like to restrict my views on Fresenius Kabi to specifics.
Fresenius Kabi Oncology is 90% owned by the German parent through its Singapore subsidiary and there is time until 3rd June 2013 to either reduce their holding to 75% or to delist the stock.
I would stick my neck out to virtually rule-out the first option (doing a QIP to divest 15% stake) and say that delisting is the ONLY option. Here's my logic
The 10% public holding is widely distributed among 41,817 shareholders, of which 39,635 are retail investors (ironically, as the face value per share is INR 1, this category covers shareholders holding shares having market value up to INR 1.53 crores and hence not strictly retail) - there is no shareholder (institutional or otherwise) who owns more than 1% of the company - total institutional holding is just 2.67%, scattered across 20 investors
Fresenius Kabi Oncology (formerly Dabur Pharma) has NO investor relations machinery in India and this has been the case ever since they acquired the company from the Burmans and NO IR activities have been carried out at all (all information sharing is to be done only at a parent level, as far as interacting with investors / media goes and the global team has repeatedly declined to share strategy for specific countries - in fact, the communication is restricted to what is contained in the standardized global business updates in the form of press / investor releases / annual reports etc)
The Indian subsidiary has absolutely ZERO coverage from a research perspective, which is a logical result of the complete secrecy on the operations and unwillingness to talk to investors / media and absolutely ZERO visibility with investors
As a part of the acquisition, Fresenius also acquired rights to all existing products developed and commercialized by Dabur Research Foundation (DRF) and the team of scientists
The Indian operations have been highly R&D focused and the company spent INR 45.47 crores in FY11 [which is more than 30% of its EBITDA (pre-R&D)] which is significantly higher than the proportionate R&D spends of the average Indian corporate
Investors in India are not sophisticated enough and do not have an appetite for the risks and rewards associated with such R&D spends as has been demonstrated with a lot of companies which focus on building their own pipeline of research products; valuing them involves placing a probability adjusted option value to various research initiatives and companies such as Suven Lifesciences are trading at huge discounts to fair values - benefits can't be captured in the increasingly limited time frames that most public market investors look for these days and most private market investors do not have a mandate from their investors wide enough to allow them to take such risks - retail investors anyways are extremely headline focused (and fail to see beyond the numbers; unfortunately this is true for a number of institutional investors too, who are taking a myopic view towards research)
In the case of Fresenius of course, there is no information that has been shared with investors to showcase the potential upsides from the ongoing R&D initiatives and therefore, there is no way to ascribe a value to it
Purely based on earnings, the stock seems richly valued at 36.87x annualized FY12 EPS and EV of 36.62x annualized FY12 EBITDA
While there are positive developments in terms of potential CRAMs revenues from the Group, just like other strategic initiatives for India, there has been complete secrecy on the potential financial upsides
Under the current regulatory environment, the only route available for Fresenius to prune its stake in the Indian operations to 75%, should they wish to do so, is a Qualified Institutional Placement (QIP), which would mean a significantly higher amount of disclosures to enable price discovery
There is no reason to believe that the parent is prepared to make the level of disclosures required for any capital raising exercise, leave alone a QIP issuance
There is no reason to believe that the parent has any inclination to prune its holding in the Indian operations but has in fact made all the noises in terms of signalling that they see increased importance for the India operations from a global context
Even if one hypothetically assumes that they decide to go down the route of a QIP, I have serious doubts on institutional interest in the stock at these levels, which means the parent would have to sell at a significant discount.
Fresenius Group does not generally list subsidiaries separately in any geography - the fact that the Indian arm is listed is due to the historical fact - it does however have multiple listings in Germany and on other European bourses for the 3 main business units which it broadly aligns itself under.. the business listed in India is a part of Kabi (which is one of the 3 business units)
The group already has an unlisted operational entity in India, which is wholly-owned for the other business units
As indicated earlier, the parent has been increasing focus on India as can be demonstrated by the following initiatives in May 2011:
The parent took a strategic call to leverage the R&D and manufacturing competencies by entering into CRAMS agreements with the parent and its affiliates for future products without affecting existing product business and Intellectual Property Rights (IPRs).
It also decided to enter into a distribution agreement with the listed company for selling and marketing products of Fresenius Kabi India Private Limited (the unlisted arm) in India.
While it is difficult to pin-point the revenue potential from these strategic initiatives, I don't think it would be an over-statement to say that it could be more than USD 100mn over the next 2 years, from here on in.
Now that I think the case for why delisting is a fait accompli on the Fresenius Kabi Management's mind has been made, let's focus on the modalities and timelines as I see it. As per the regulations, a reverse book building process will have to be initiated and at least 50% of the public shareholding i.e. 5% additional stake needs to be acquired.
Given how widely scattered the shareholding is and given the strategic value of the Indian business in the overall scheme of things and the hanging sword of June 3, 2013, I wouldn't be surprised if intention to delist could be made public in the near future and process initiated within the next 3-4 months.
The risks of a failed delisting offer are too high and the marginal cost of potentially 'over-paying' for the Indian operation is too low for the parent and I would expect them to settle for a delisting price of INR 225 per share, a premium of 47% over the current market price. From a future earnings potential point-of-view as well as asset base point-of-view, I wouldn't say that paying 25x potential FY14 earnings is unacceptable (assuming a 50% CAGR in earnings over 2 years).
The stock has outperformed the markets in recent months but it still merits accumulation at every decline and I would say a 10% allocation to one's portfolio is advisable.
It is a matter of common knowledge that Swelect Energy Systems (formerly Numeric Power Solutions) listed on both BSE and NSE has sold its UPS business to affiliates of Legrand France S.A. for an aggregate consideration of INR 829 crores (including USD 4.5mn for the Singapore subsidiary). Pursuant to announcement of the sale in early Feb '12, the stock did run up for a couple of days, hitting a high of 308/309. However, given that the deal was subject to various approvals and more importantly, owing to concerns about how the promoters would use the cash, the stock corrected shortly thereafter and was later transferred to T group. The stock is languishing at 260 levels with thin trading volumes.
Before I share my views on the company and how I see the story going ahead, I'd like to issue a caveat that I have always liked the company, as most value investors have and I own the stock, therefore, my views should be considered as biased.
I believe this is a perfect time to buy the stock.
First the situation angle for the 'positional traders' - April 10th (tomorrow) is the last date of consummation of the transaction, mutually agreed upon between Numeric and Legrand. Therefore, I would assume an announcement on this front and receipt of cash is imminent. I would also assume that calling of a board meeting for declaration of a special dividend (which the promoters have been clear will be the mode used to distribute some of the cash) is also imminent. While no one knows how generous these guys would be in terms of distribution of the cash, my personal take is that the dividend would be 125-150 bucks a share. The above announcements should be sufficient to result in a 50-60 buck up-move in the stock. The fact that the stock was transferred to T group should in fact be looked as a blessing in disguise as the speculative element built into the stock is therefore low.
Now the more important fundamental call for 'investors'. I have a positive bias towards promoters based in Chennai; given that they more often than not have corporate governance standards better than those prevalent in Hyderabad or Delhi and err on the side of conservatism rather than being adventurous. More specifically, I have always liked the Numeric management, given that like many other Chennai based companies, they have never been 'capital market savvy' and have built the entire business organically from internal accruals, without any dilution whatsoever, besides the negligible sum they raised through an IPO. That's an enviable track record to have for a promoter for sure. Moreover, promoters do not have any unrelated business interests (to my knowledge) and have stayed away from the temptation to invest in real estate and such areas (which is often seen as the easiest way to deploy large pools of capital). If one looks around for parallels, we have seen how Chennai based Amrutanjan has created value for shareholders post sale of some of its surplus assets.
If one looks at the flipside, markets gave a thumbs down to Piramal when they announced the sale of their business to Abbott and hammered the stock down to 340 levels but as clarity has emerged on some of their plans to deploy the cash, the stock did bounce back almost 40% from those levels. In case of Piramal of course, while I believe they will create shareholder value over the long-term, some of the calls they have taken are quite adventurous, to say the least - be it the Vodafone deal or be it direct lending to real estate companies from the listed company. (Yes, the latter is indeed true, although they haven't publicly spoken about it - interactions with their NBFC subsidiary clearly point in this direction). The extreme case would be companies promoted by relatively obscure promoters like Geecee Ventures (formerly Gwalior Chemicals), which have decided to use the book to invest in third-party businesses using a PE approach.
Coming to Swelect Energy (market cap ~INR 260 crores), here's how I would look to value the business:
Consolidated net debt as of FY11 was INR 23 crores and post this transaction, the company would have net cash of INR 650+ crores.
Their residual (non-UPS) business did INR 111 crores in FY11 and while the business-wise split is not readily available, my sense is it would be largely the project management and LED lighting businesses. The skill sets that Numeric used in growing the UPS business should be quite handy in terms of growing the LED lighting business. I'm fairly bullish on this piece delivering steady growth. The solar project management business (EPC contracts and O&M services) is a fast growing business and has seen advent of many serious players in the last two years. There is also a steel foundry business, manufacturing mainly alloy steel castings and valves - specifically for the oil and gas industry, housed in a subsidiary Amex Alloys - expected to do a top line of INR 35 crores this fiscal. In a nutshell, I would conservatively peg the value of these residual businesses at INR 100 crores.
The company has sold only 3 of its 9 manufacturing facilities to Legrand as part of the deal - the real estate value of the remaining facilities could easily be another INR 50 crores. (but some of these could be used for the LED lighting business)
The green energy business looks particularly exciting, given that Tamil Nadu is probably the best place for setting up of wind farms and the company has plans to increase capacity from 1.5MW to 10MW. On the solar side, while they are again looking to invest in the generation side of the business, detailed business plans are still in the works. They are the 3rd company in India and 1st in Tamil Nadu to get REC accreditation for its two 1MW solar PV plants in Tamil Nadu. In other words, they will get market trade-able renewable energy certificates for the power this Coimbatore plant generates - it is expected to start pumping electricity into the grid as early as this month. The equity value of the existing business on the renewable side (based on up and running capacities) should be INR 20 crores.
The next generation seems to be adequately qualified to drive the renewable energy business and I believe Mirunalini Chellappan, the daughter of the promoter has been working on preparing a blue print for Numeric's foray in this space for over 3 years now, since her induction into the business.
I would continue to place my bet on the Management in terms of their execution capabilities on energy efficient lighting solutions and renewable side.
Over the next 1 year, I would expect the company to begin trading closer to cash value and depending on how the strategy plays itself out, over the next 3 years, investors could see more value accretion.
I'd conclude by saying that to my mind, the stock merits a 10% portfolio allocation with a buy and hold strategy for investors with an upside potential of 100% over a 12 month period.
Background
Based on a global survey of investment bankers, private equity companies, and financial analysts, Deloitte's study The Leadership Premium: How companies win the confidence of investors puts a quantitative metric on the effectiveness of leadership to help businesses understand the impact that leadership can have on their performance and market value.
Key findings
The report reveals that the quality of senior leadership—including core capabilities as well as personal qualities such as honesty and integrity—has a direct, and measurable, impact on analysts' assessments of whether companies have been successful and will be successful in the future.
More than 50 percent of stock market analysts surveyed routinely factor leadership into their valuations—and 80 percent award a premium for particularly effective senior teams.
The report indicates that analysts look for three core components when assessing an organisation's leadership strength:
Strategic clarity – a clear vision of what the organisation needs to achieve.
Successful execution – proven ability to meet objectives.
A culture of innovation – commitment to enterprise; an environment for ideas.
In addition, analysts look for two attributes that support these components: effective corporate governance and effective leadership characteristics.
1 of 1 File(s)
uk-con-winning-confidence-of-investors.pdf
Investors are familiar with the boom in commodity prices and experience the effects of rising prices for those they use, petrol being the most obvious. Australian investors are "enjoying" the fruits of the boom through the high inflows of capital into our economy, and at the same time suffering under the high interest rates the inflation-fighting Reserve Bank of Australia is imposing in response.
So investing in commodities should be a way to generate returns as well as a hedge to protect your investments against the rising costs flowing from the boom. Because Australia is apparently in a long-term commodities "supercycle" - linked to the urbanisation and industrialisation of China, India and other emerging economies - we ought to be thinking that investing in commodities is important now and for the future.
It is not that simple. Post-GFC investor scepticism combined with the "black box" of commodity prices - how much of the price is driven by hedge fund speculation and hoarding? - has traditionally forced most investors to stay away from commodities as an asset class.
This article provides a balanced analysis of the pros and cons of agricultural commodity investing and how to include it in portfolios, with guidance on how to interpret and react to the "noise" surrounding commodities. There has been a huge shift in the production and consumption of most commodities, with agricultural (soft) commodities subject to the same explosive demand growth that is driving prices for hard commodities.
Portfolio efficiency can be improved by including 5-10 per cent agricultural commodity exposure by, for example, using the BetaShares ETF (ASX code: QAG).
Commodity boom sustainability
Commentators say the current commodity boom is driven by the growth and industrialisation in emerging economies, which overlays the normal demand from developed economies. This typically leads to research by brokers and investment managers that encourages investors to buy resource-related shares and also invest in the underlying commodities. In parallel, we also hear claims that the China story is a bubble waiting to burst and that economic growth in emerging markets is likewise uncertain.
With a heavy dose of scepticism in mind, let's look at the evidence of how real this commodities boom is, what are the enduring sources of high prices, and what are the risks for investors. We will see that the drivers of demand for the soft agricultural commodities (wheat, rice, corn, etc) are very similar to those of hard commodities (iron ore, coal, copper, etc).
The Reserve Bank of Australia is one of the most consistently accurate economic forecasters available to us. In November 2010 its governor, Glenn Stevens, highlighted how much stronger the commodities boom was than any of its predecessors.
Australian Terms of Trade
Source: RBA
Stevens noted that commodity prices have always experienced a "boom and bust" cycle in Australia, going so far as to say the RBA assumes that iron ore prices will moderate over coming years as supply increases to match demand. Yet he was clear that there was a reasonable basis for the view that the boom may be "longer and stronger" than previous ones.
The chart above, which Stevens used in his speech to the Committee for Economic Development of Australia (CEDA), makes it clear that, despite the various booms during the 19th and 20th centuries, the long-term trend in commodity prices was downward for all of the 20th century. This leads many commodity sceptics to predict the current boom may just be a blip in demand, and therefore commodity investing will end in tears.
A great source of analysis comes from the eminent investor Jeremy Grantham, founder of investment house GMO. As a noted sceptic of broker and investment bank claims about rising asset prices, his detailed analysis of the "paradigm shift" in commodity prices is a must read for all investors. This is what he says about the current commodity boom:
"…we now live in a different, more constrained, world in which prices of raw materials will rise and shortages will be common…accelerated demand from developing countries, especially China, has caused an unprecedented shift in the price structure of resources. After 100 years or more of price declines, they are now rising and in the last eight years have undone, remarkably, the effects of the 100-year price decline."
Grantham names the Chinese industrial revolution, which grew exponentially after China joined the World Trade Organisation in 2001, as the primary source of the "great paradigm shift" in commodity prices.
The table below shows how extensive Chinese demand is for commodities.
Source: Barclays Capital (2010), Credit Suisse (2010), Goldman Sachs, United States Geological Survey (2009), BP Statistical Review of World Energy (2009), Food and Agriculture Organization of the United States (2008), International Monetary Fund (2010).
Note that China's demand for agricultural commodities sits side by side with its demand for hard commodities. China now accounts for 28.1 per cent of the global demand for rice, 24.6 per cent of soybeans, 16.6 per cent of wheat, and nearly half the entire demand for pork.
It is no wonder the rise of China and other emerging economies is fuelling such a significant increase in commodity prices. The graph below illustrates this with iron ore prices.
Iron Ore prices chart - 1900 to 2010
Source: Global Financial Data, as of 31/12/10
The case for investing in agricultural commodities
The urbanisation and industrialisation of the emerging economies, led by China and India, has many facets. Demand for hard commodities comes from the building of infrastructure needed to house and transport the hundreds of millions of people moving from rural to city life.
Their jobs in the cities are typically far more productive of national wealth than their lives as farmers. This leads to rising national GDP, which directly creates rising household GDP. As household incomes rise, more citizens consume more electrical and whitegoods, thus increasing demand for hard commodities. The quality of food improves, with rising consumption of protein and calories. This directly leads to higher demand for the key soft commodities of wheat, rice, soybeans, etc.
The finite supply of hard commodities is a primary reason for their rising prices, compounded by the higher cost of extracting and processing lower-quality deposits, which is necessary as higher-quality deposits are mined out. It is the same with agricultural commodities: as demand grows, production moves to marginally lower-quality land. This is exacerbated by the growth in size and number of urban centres; typically cities are established in geographic regions with good supplies of water and good growing conditions for crops. As cities grow, they overwhelm the best agricultural land. Australians know this only too well with urban sprawl.
Agricultural productivity has been helped over the past few decades by improved fertilizers and farming techniques. Even though total output has risen, the efficiency of agriculture is falling because of the declining quality of land used. The graph below shows this decline is permanent, and there will be a fundamental shift as petrochemical-based fertilizers become more expensive.
Agricultural productivity chart - 1971 to 2006
Source: Food Agriculture Organization of the United National, as of 31/12/2009
It is little wonder that the prices of the four key agricultural commodities - wheat, rice, soybeans and corn - are high, and moving higher.
Portfolio construction with agricultural commodities
The problem for investors is that it is impossible to buy most physical commodities unless you are a supplier or end-user of them. How does a retail investor store an investment in wheat?
Investors seeking exposure to commodity prices have traditionally done so through owning shares in commodity companies. This works reasonably well with hard commodities, but is difficult to do in agriculture. The total exposure to soft commodities of companies in the ASX 200 is less than 1 per cent.
As a result, various commodity indices have been developed to provide a convenient method of investment in agricultural commodities. The graph below shows the performance of the leading global commodity index, the S&P GSCI index, compared to that of the ASX 200 and the S&P 500.
Commodity index comparisons
Source: BetaShares
BetaShares provides a range of commodity ETFs, including a diversified commodity basket (ASX code: QCB), an energy ETF (ASX code: OOO), a gold bullion ETF (ASX code: QAU) and a metals ETF (ASX code: QCP). The BetaShares agriculture commodity ETF (ASX Code: QAG) tracks the S&P GSCI Agriculture Enhanced Select Index and is a useful tool for blending with more traditional assets such as Australian or international shares.
The graph below shows how the performance of an Australian equities portfolio can be improved by the inclusion of a 10 per cent allocation to QAG.
Australian equities portfolio with inclusion of 10% allocation to QAG
Source: Mercer, BetaShares. Blending QAG with ASX 200.
Conclusions
Driven by the urbanisation and economic growth in emerging economies, and decreasing rates of agricultural productivity, agricultural commodities prices are rising and should continue to do so as these fundamentals continue their trend growth. A portfolio allocation into the BetaShares agricultural ETF QAG improves the overall return and portfolio efficiency for retail investors.
About the author
Tony Rumble, PhD, is Head of Portfolio Construction, BetaShares. Email Tony.
Important: This information has been prepared by BetaShares Capital Ltd (ACN 139 566 868 AFS Licence 341181), the product issuer. It is general information only and does not take into account your objectives, financial situation or needs so it may not be appropriate for you. Before making an investment decision regarding any BetaShares ETF you should consider the relevant product disclosure statement ('PDS') and your circumstances and obtain financial advice. The PDS is available at www.betashares.com.au. An investment in any BetaShares ETF is subject to investment risk including possible delays in repayment and loss of income and principal invested. Past performance is not an indication of future performance. Standard and Poor's® and S&P® are registered trademarks of The McGraw-Hill Companies, Inc. ("McGraw-Hill"), and ASX® is a registered trademark of the ASX Operations Pty Ltd ("ASX"). These trademarks have been licensed for use by BetaShares. BetaShares ETFs are not sponsored, endorsed, sold or promoted by S&P, McGraw-Hill or ASX, and S&P, McGraw-Hill and ASX make no representation, warranty or condition regarding the advisability of buying, selling or holding units in BetaShares ETFs.
From ASX
ASX Exchange Traded Commodities (ETCs) provides useful information about how to use ETCs to gain pure exposure to commodities.
The views, opinions or recommendations of the author in this article are solely those of the author and do not in any way reflect the views, opinions, recommendations, of ASX Limited ABN 98 008 624 691 and its related bodies corporate ("ASX"). ASX makes no representation or warranty with respect to the accuracy, completeness or currency of the content. The content is for educational purposes only and does not constitute financial advice. Independent advice should be obtained from an Australian financial services licensee before making investment decisions. To the extent permitted by law, ASX excludes all liability for any loss or damage arising in any way including by way of negligence.
© Copyright 2012 ASX Limited ABN 98 008 624 691. All rights reserved 2012.
So investing in commodities should be a way to generate returns as well as a hedge to protect your investments against the rising costs flowing from the boom. Because Australia is apparently in a long-term commodities "supercycle" - linked to the urbanisation and industrialisation of China, India and other emerging economies - we ought to be thinking that investing in commodities is important now and for the future.
It is not that simple. Post-GFC investor scepticism combined with the "black box" of commodity prices - how much of the price is driven by hedge fund speculation and hoarding? - has traditionally forced most investors to stay away from commodities as an asset class.
This article provides a balanced analysis of the pros and cons of agricultural commodity investing and how to include it in portfolios, with guidance on how to interpret and react to the "noise" surrounding commodities. There has been a huge shift in the production and consumption of most commodities, with agricultural (soft) commodities subject to the same explosive demand growth that is driving prices for hard commodities.
Portfolio efficiency can be improved by including 5-10 per cent agricultural commodity exposure by, for example, using the BetaShares ETF (ASX code: QAG).
Commodity boom sustainability
Commentators say the current commodity boom is driven by the growth and industrialisation in emerging economies, which overlays the normal demand from developed economies. This typically leads to research by brokers and investment managers that encourages investors to buy resource-related shares and also invest in the underlying commodities. In parallel, we also hear claims that the China story is a bubble waiting to burst and that economic growth in emerging markets is likewise uncertain.
With a heavy dose of scepticism in mind, let's look at the evidence of how real this commodities boom is, what are the enduring sources of high prices, and what are the risks for investors. We will see that the drivers of demand for the soft agricultural commodities (wheat, rice, corn, etc) are very similar to those of hard commodities (iron ore, coal, copper, etc).
The Reserve Bank of Australia is one of the most consistently accurate economic forecasters available to us. In November 2010 its governor, Glenn Stevens, highlighted how much stronger the commodities boom was than any of its predecessors.
Australian Terms of Trade
Source: RBA
Stevens noted that commodity prices have always experienced a "boom and bust" cycle in Australia, going so far as to say the RBA assumes that iron ore prices will moderate over coming years as supply increases to match demand. Yet he was clear that there was a reasonable basis for the view that the boom may be "longer and stronger" than previous ones.
The chart above, which Stevens used in his speech to the Committee for Economic Development of Australia (CEDA), makes it clear that, despite the various booms during the 19th and 20th centuries, the long-term trend in commodity prices was downward for all of the 20th century. This leads many commodity sceptics to predict the current boom may just be a blip in demand, and therefore commodity investing will end in tears.
A great source of analysis comes from the eminent investor Jeremy Grantham, founder of investment house GMO. As a noted sceptic of broker and investment bank claims about rising asset prices, his detailed analysis of the "paradigm shift" in commodity prices is a must read for all investors. This is what he says about the current commodity boom:
"…we now live in a different, more constrained, world in which prices of raw materials will rise and shortages will be common…accelerated demand from developing countries, especially China, has caused an unprecedented shift in the price structure of resources. After 100 years or more of price declines, they are now rising and in the last eight years have undone, remarkably, the effects of the 100-year price decline."
Grantham names the Chinese industrial revolution, which grew exponentially after China joined the World Trade Organisation in 2001, as the primary source of the "great paradigm shift" in commodity prices.
The table below shows how extensive Chinese demand is for commodities.
| Commodity | China % of World |
|---|---|
| Cement | 53.2% |
| Iron Ore | 47.7% |
| Coal | 46.9% |
| Pigs | 46.4% |
| Steel | 45.4% |
| Lead | 44.6% |
| Zinc | 41.3% |
| Aluminum | 40.6% |
| Copper | 38.9% |
| Eggs | 37.2% |
| Nickel | 36.3% |
| Rice | 28.1% |
| Soybeans | 24.6% |
| Wheat | 16.6% |
| Chickens | 15.6% |
| PPP GDP | 13.6% |
| Oil | 10.3% |
| Cattle | 9.5% |
| GDP | 9.4% |
Note that China's demand for agricultural commodities sits side by side with its demand for hard commodities. China now accounts for 28.1 per cent of the global demand for rice, 24.6 per cent of soybeans, 16.6 per cent of wheat, and nearly half the entire demand for pork.
It is no wonder the rise of China and other emerging economies is fuelling such a significant increase in commodity prices. The graph below illustrates this with iron ore prices.
Iron Ore prices chart - 1900 to 2010
Source: Global Financial Data, as of 31/12/10
The case for investing in agricultural commodities
The urbanisation and industrialisation of the emerging economies, led by China and India, has many facets. Demand for hard commodities comes from the building of infrastructure needed to house and transport the hundreds of millions of people moving from rural to city life.
Their jobs in the cities are typically far more productive of national wealth than their lives as farmers. This leads to rising national GDP, which directly creates rising household GDP. As household incomes rise, more citizens consume more electrical and whitegoods, thus increasing demand for hard commodities. The quality of food improves, with rising consumption of protein and calories. This directly leads to higher demand for the key soft commodities of wheat, rice, soybeans, etc.
The finite supply of hard commodities is a primary reason for their rising prices, compounded by the higher cost of extracting and processing lower-quality deposits, which is necessary as higher-quality deposits are mined out. It is the same with agricultural commodities: as demand grows, production moves to marginally lower-quality land. This is exacerbated by the growth in size and number of urban centres; typically cities are established in geographic regions with good supplies of water and good growing conditions for crops. As cities grow, they overwhelm the best agricultural land. Australians know this only too well with urban sprawl.
Agricultural productivity has been helped over the past few decades by improved fertilizers and farming techniques. Even though total output has risen, the efficiency of agriculture is falling because of the declining quality of land used. The graph below shows this decline is permanent, and there will be a fundamental shift as petrochemical-based fertilizers become more expensive.
Agricultural productivity chart - 1971 to 2006
Source: Food Agriculture Organization of the United National, as of 31/12/2009
It is little wonder that the prices of the four key agricultural commodities - wheat, rice, soybeans and corn - are high, and moving higher.
Portfolio construction with agricultural commodities
The problem for investors is that it is impossible to buy most physical commodities unless you are a supplier or end-user of them. How does a retail investor store an investment in wheat?
Investors seeking exposure to commodity prices have traditionally done so through owning shares in commodity companies. This works reasonably well with hard commodities, but is difficult to do in agriculture. The total exposure to soft commodities of companies in the ASX 200 is less than 1 per cent.
As a result, various commodity indices have been developed to provide a convenient method of investment in agricultural commodities. The graph below shows the performance of the leading global commodity index, the S&P GSCI index, compared to that of the ASX 200 and the S&P 500.
Commodity index comparisons
Source: BetaShares
BetaShares provides a range of commodity ETFs, including a diversified commodity basket (ASX code: QCB), an energy ETF (ASX code: OOO), a gold bullion ETF (ASX code: QAU) and a metals ETF (ASX code: QCP). The BetaShares agriculture commodity ETF (ASX Code: QAG) tracks the S&P GSCI Agriculture Enhanced Select Index and is a useful tool for blending with more traditional assets such as Australian or international shares.
The graph below shows how the performance of an Australian equities portfolio can be improved by the inclusion of a 10 per cent allocation to QAG.
Australian equities portfolio with inclusion of 10% allocation to QAG
Source: Mercer, BetaShares. Blending QAG with ASX 200.
Conclusions
Driven by the urbanisation and economic growth in emerging economies, and decreasing rates of agricultural productivity, agricultural commodities prices are rising and should continue to do so as these fundamentals continue their trend growth. A portfolio allocation into the BetaShares agricultural ETF QAG improves the overall return and portfolio efficiency for retail investors.
About the author
Tony Rumble, PhD, is Head of Portfolio Construction, BetaShares. Email Tony.
Important: This information has been prepared by BetaShares Capital Ltd (ACN 139 566 868 AFS Licence 341181), the product issuer. It is general information only and does not take into account your objectives, financial situation or needs so it may not be appropriate for you. Before making an investment decision regarding any BetaShares ETF you should consider the relevant product disclosure statement ('PDS') and your circumstances and obtain financial advice. The PDS is available at www.betashares.com.au. An investment in any BetaShares ETF is subject to investment risk including possible delays in repayment and loss of income and principal invested. Past performance is not an indication of future performance. Standard and Poor's® and S&P® are registered trademarks of The McGraw-Hill Companies, Inc. ("McGraw-Hill"), and ASX® is a registered trademark of the ASX Operations Pty Ltd ("ASX"). These trademarks have been licensed for use by BetaShares. BetaShares ETFs are not sponsored, endorsed, sold or promoted by S&P, McGraw-Hill or ASX, and S&P, McGraw-Hill and ASX make no representation, warranty or condition regarding the advisability of buying, selling or holding units in BetaShares ETFs.
From ASX
ASX Exchange Traded Commodities (ETCs) provides useful information about how to use ETCs to gain pure exposure to commodities.
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Cushla Sherlock: Not long ago India was hoping to help lead the world in growth, what went wrong? Is the slowdown permanent?
Deepak Parekh: The slowdown is definitely evident, but I'm confident that it is temporary. In the last decade, India grew at over 9 percent for three consecutive years and the aspiration was that we would achieve double digit growth. Unfortunately global GDP slowed, and as a result, so did we. Compared to the last couple of years, where we experienced a GDP growth rate of over 8 percent, this year we are in a bad shape and will come down to 6.9 or 7 percent. That indicates that the slowdown is definitely there, but I don't think it's permanent for a number of reasons.
What are the reasons?
We've had policy paralysis in the government. Various decisions have not been taken by the present ruling government because the coalition partners are not gelling and the opposition is not playing ball. As a result the government is unable to take reforms forward.
Some steps have already been taken, are these going in the right direction?
The government has accelerated some decision-making particularly with respect to fuel supply, whether coal or any other raw material needed for power, because without adequate power for industry you cannot achieve a larger GDP growth. These reforms in the power sector indicate that government is well aware of the slowdown need for action.
Is it worthwhile for investors to build exposure to India now?
Yes. I think some shares and equities have been battered down, not because the intrinsic values are not there, but because they are not able to get adequate raw materials, which are government controlled. We had a couple of major scandals last year and that also slowed down the government's decision-making, but I think this is behind us: inflation is now under check, interest rates have peaked and they will only come down during the course of 2012. I expect that things will improve in the last six months of this year.
Let's continue looking forward, what will the engines of growth be in India this year?
The service sector is the engine of growth in India. Growth in this sector is about 10 percent and it constitutes almost 60 percent of GDP - the service sector is booming. Agriculture and industry contributes the balance amount and have been hit badly by industry this year. However, with decisions from the government and the fast-forwarding of some reforms, I'm very confident that the industrial growth will come back to 7 or 8 percent.
In an environment of deleveraging, and low economic growth rates in the developed world, what asset classes should investors be focussed on? Bill Gross, the Co-CEO of the world's largest bond manager PIMCO, wrote an important monthly note arguing that as we move towards a mildly reflating world (higher rates and credit spreads) investors should add risk assets and move away from negative real returns offered by cash and short-term treasuries. To summarise:
-The current process of financial deleveraging follows a multi-decade period of levering, dating back to the fractional banking system and central banking in the early 20th century, the debasement of gold in the 1930s, the creation of Bretton woods and the dollar/gold standards which followed for 3 decades after WWII, the abandonment of the gold standard in the early 1970s and the deregulation of Glass-Steagall in the 1990s.
-While there were a variety of crises during this period, including the S&L crisis, Continental Bank, LTCM, Mexico, Asia in the late nineties, the Dot-com mania, and the more recent subprime crisis, the system continued to leverage-up as the market participants were emboldened by seeing that policy makers would continue supporting the system by extending credit, expanding deficits, and deregulating.
-The combined fiscal and monetary leverage produced extraordinary returns which exceeded the ability of the economy to create real wealth. Stocks and houses were viewed to be one-way bets over the long-run and homes were even categorised as financial assets (even though they were just a pile of sticks and stones) which could be borrowed against.
-As nominal and real interest rates came down, credit spreads were suppressed by policy support and securitization, stock PE ratios rose, 30-year treasury bond prices doubled, real estate boomed and anything that could be levered did well.
-This process suddenly stopped in 2008 and started to reverse. While the private sector has been selectively delivering (i.e. US households, banks) the public sector continues to pick-up the slack causing the system as a whole to mildly expand leverage, eventually leading to global inflation and slower growth.
-During the period of leveraging, financial assets with long duration (long maturity bonds, stocks, real estate with rental streams) did exceptionally well as their future cash streams were discounted by lower rates and spreads. Wealth was brought forward from future years as real growth was not able to match financial returns.
-Commodities lagged financial assets as well (as they could not be levered and could not benefit from PE expansion) underperforming them by 2% per annum over the last 20-years.
-However, as the process now reverses with rates and spreads not being able to come down further and likely to rise slowly along with inflation, delivering double digit or even 7-8% total return from stocks, bonds or real estate becomes difficult , and relative underperformance to commodities and real assets becomes more likely.
-While inflation will elevate some financial assets like stocks, their ability to return in excess of inflation or nominal GDP growth is likely to be limited.
-The investment strategy for this environment comprises:
-Real asset like commodities (inflation sensitive and supply constrained products) , land, buildings, machines and worker knowledge.
-Developing country stocks, with emphasis on dividend paying rather than growth stocks.
-Higher quality, short duration bonds and inflation-protected bonds.
-Be wary of levered strategies that promise double-digit returns in a delevering world.
-Don't get too defensive – maximise the "risk adjusted carry" or "safe spread" to pay your bills.
-Buy some insurance against fatter tailed outcomes arising from the myriad monetary, policy, geopolitical risks out there and manage investment expenses.
A brilliant snapshot of the financial world we are in and what we can expect going forward. As I have reiterated in several newsletters, it is absolutely critical to construct a well diversified portfolio which provides enough upside under a mildly reflating world and low real growth in developed markets, while protecting against future inflation. A portfolio weighted towards EM equities, energy and commodity stocks, high quality multinational stocks, EM local currency and dollar high yield bonds, high quality developed world credits, cash, farmland and gold should meet these requirements.
Why eating less meat makes sense?:
To follow-up on the newsletter from last week which reasoned how increasing incomes in the developing world are increasing the consumption of protein and putting excessive strain on the finite supply of grains, arable land and water, I present below a report from the Harvard Health Publications (Feb/March, 2012) supporting the case for moderation in meat consumption and more emphasis on plant protein as a means to better health:
-Researchers at the Harvard School of Public Health have been following 85,000 female nurses and 45,000 male health professionals since the mid-1980s. Every few years, the participants fill out questionnaires detailing what they eat and provide other information on their health.
-In one study, the researchers created scores for each nurse's intake of protein from red meat, poultry, fish, dairy, eggs, nuts, and beans. The findings:
- The more protein from red meat, the higher the chances of developing heart disease.
- Women who averaged two or more servings of red meat a day had a 30% higher risk of developing heart disease than those who had one or fewer servings a day.
- Replacing one serving of meat with one of nuts reduced the risk by 30%.
-In a separate study, the researchers created scores that reflected both the amount of carbohydrate in the diet and the main sources of protein. Among the nurses and male health professionals, those with a low-carb diet heavy in animal protein were 23% more likely to have died over 20-plus years of follow-up than those with "regular" diets, while those following a low-carb diet rich in plant protein were 20% less likely to have died.
--The authors of the study suggest that the increased risk from red meat may come from the saturated fat, cholesterol, and iron it delivers. Potentially cancer-causing compounds generated when cooking red meat at high could also contribute. Sodium, particularly in processed foods, may also play a role. It's also possible that red-meat eaters may be more likely to have other risk factors for serious, life-shortening diseases
-Good sources of protein deliver different amounts of saturated fats, carbohydrates, and fiber. Here's what 3 ounces of different protein sources contain.
Food
|
Calories
|
Protein (g)
|
Carbohydrate (g)
|
Saturated fat (g)
|
Roasted chicken, white meat
|
130
|
23.1
|
0
|
0.9
|
Roasted leg of lamb
|
184
|
22.7
|
0
|
3.9
|
Cooked ground beef (85% lean)
|
197
|
20.9
|
0
|
4.5
|
Baked coho salmon
|
151
|
20.7
|
0
|
1.7
|
Roasted chicken, dark meat
|
151
|
19.8
|
0
|
2.1
|
Baked ham
|
151
|
19.2
|
0
|
2.7
|
Boiled green soybeans
|
127
|
11.1
|
10
|
0.7
|
Cottage cheese, 1% milk fat
|
61
|
10.5
|
2.3
|
0.6
|
Boiled black beans
|
114
|
7.6
|
20
|
0.1
|
Source: USDA National Nutrient Database
| ||||
-To your body, protein from pork chops looks and acts the same as protein from peanuts. What's different is the protein "package" — the fats, carbohydrates, vitamins, minerals, and other nutrients that invariably come along with protein. The two Harvard studies add to a growing body of evidence that emphasizing plant protein sources is a better bet for long-term health.
-If you are overweight, shedding pounds can improve everything from your blood pressure to the way you feel. Do it the wrong way, though, and shrinking your waistline could also shrink the number of birthdays you get to celebrate. Instead of having bacon and eggs for breakfast, a burger for lunch, and steak for dinner, getting more of your protein from plants may help you steer clear of heart disease and live longer.
-One way to cut back on red meat is to follow a Mediterranean-style diet. It is rich in plant-based foods, and doesn't emphasize meat.- Eat fruits, vegetables, whole grains, beans, nuts, and seeds every day; they should make up the lion's share of foods.
- Fat, much of it from olive oil, may account for up to 40% of daily calories.
- Small portions of cheese or yogurt are usually eaten each day, along with a serving of fish, poultry, or eggs.
- Red meat makes an appearance now and then.
- Small amounts of red wine are typically taken with meals.
To eating less meat and more plant protein!
Research indicates that for most investors, tuning out the noise and sticking to their portfolio plan may be their best path to success.
These days, it’s not simply Homer Simpson that is uttering the famous TV catchphrase, “d’oh!” Some shaken investors who ran for the door in late 2008 and early 2009 are feeling stunned and bewildered at the markets dramatic recovery. As of March 9, 2009, three short years ago, the DOW sank to a shocking 6,547. Today, the DOW has boldly marched past the 13,000 mark, well above the pre-crash 11,543 close of August 2008. Investors who simply tuned out the drama and did little more than follow through with their portfolio plan consisting of low-cost diversification and disciplined rebalancing, are now rejoicing. Could such a simple approach be a key to good portfolio management?
The Roller Coaster from Hell
When it comes to roller coasters, even the youngest children know they should remain buckled in their seat until the ride deposits them safely back on terra firma. Unfortunately, for investors, the stock market allows a panicked rider to hit the eject button midcourse in spite of the risk of being thrown headlong to an ignominious demise.
According to research by Drs. Joy and Layton Smith, professors of Finance at Coggin College, this is exactly what many investors in fact did. Gripped by fear from both the market collapse of 2009 and the Flash Crash of 2010, a majority of investors abandoned their portfolio plan in a “flight to quality”. The roller coaster drama of watching a life of hard work and disciplined savings be hewn in half in a few short and horrific months was, for most, too much to bear.
Like an ultimate fighter suffering an unbearable chokehold, investors “tapped out” in a “flight to quality” – selling their stocks in favor of treasury bonds. Investors no longer cared that bond yields produced less than the annual inflation rate. They wanted off the crazy train and were in desperate need of security.
The Power of a Plan
In the late nineteen-sixties, Walter Michel, a Stanford professor of psychology performed the now historic Bing studies more commonly known as the marshmallow test. In this study, researches sat four year-old children at a table in a private room, marshmallow temptingly placed in front of them on a solitary plate. The kids where further told that the instructor must leave the room but would be back shortly. If they wanted, they could eat the marshmallow at any time, but if they waited for the instructor’s return, they would receive a second marshmallow as a reward.
On average, children lasted about three minutes before caving into desire and consuming the treat. However, thirty percent of the children lasted the entire fifteen-minute wait, receiving the reward of a double portion.
It is no surprise that after tracking of these children into adult life, those with the ability to delay gratification had greater success across many areas of life. One of the remarkable insights of the Bing studies, however, was in how children successfully in delaying gratification – something us shot delayers need help with. The high delayers approached the stress of the marshmallow temptation quite different from the majority – via something researchers called strategic allocation of attention. Instead of sitting there and getting obsessed with the marshmallow or “hot stimulus”, the children distracted themselves with other activities, like playing hide-and-seek underneath the desk, singing songs or moving about the room. Their desire wasn’t defeated – it was intentionally ignored via a distraction plan.
A simple analysis of the past three years demonstrates how this same skill worked for some investors. Take for instance a simple $1M portfolio of 50% stocks via the SPDR S&P 500 ETF, SPY, and 50% bonds via the Vanguard Total Bond Market ETF, BND. If an investor had simply made those purchases on August 1 of 2008, turned off every news source and spent the last three years gardening or playing with the grandkids, as of March 9, 2012 that investor’s account would be a robust $1,213,140 with a return of 21.32%. Not too shabby a three-year return for the worst market in modern history.
Now what happens if that same investor added the basic discipline of rebalancing according to the pre-established portfolio plan? The MarketRiders analytics engine reveals that such an investor would have been alerted to rebalance eight times over those three years. The results of the rebalancing are that the investor enjoyed account growth to $1,260,598, or a return of 26.07% – a 4.75% outperformance to the unbalanced equivalent.
Founder of the Vanguard Group and white hat, John Bogle, wrote, “Stay the course. No matter what happens, stick to your program. I’ve said ‘stay the course’ a thousand times, and I meant it every time. It is the most important single piece of investment wisdom I can give to you.”
As much as investors believe that they can anticipate the downturns and time the market, research repeatedly debunks this myth. This three-year anniversary of the downturn has once again illustrated that bailing out of even the simplest of portfolio plans is an easy way to torpedo your investment program. Yes, this turbulent journey sure felt hopeless at times, but steadfast investors understood the dictum – this too shall pass. Like the kids with the marshmallows, staying focused on the plan helped such investors resist the temptation to react, and in the end, they move a little closer to their reward of a double portion.
