Picking the winners

Investors focusing more on volume and cost efficiency than prices have best long-term prospects

In the world of commodities, the past couple of years should be viewed as an abrasive palate cleanser between the first course of the supercycle, which ran from 2000 until 2008, and the main course that is now being prepared.

To understand why, one first needs to re-examine the specifics of China's recent nominal US dollar GDP growth - an extraordinary compound annual growth rate of 18.5 percent over the past decade. Even now China's nominal US dollar GDP - the pool of demand that matters most to business - is still growing in the region of 13 percent annually.

One also needs to develop a proper understanding of the sheer scale of the compounding effect that is now happening on China's ever increasing economic base. This means not being hypnotized by the annual growth rate but rather focusing on the sheer quantum of new Chinese US dollar demand for commodities that is likely to be created in each successive year over the coming decade. In 2012, China added an Australia to its economy; by 2020, it could be adding a Germany every year.

In the era ahead, it is important to understand that, just as the character of China's growth is changing in line with the rise of the Chinese consumer, so too the mix of that commodity demand is evolving. The winners in the first course are not necessarily going to be the same winners in the main course, though some ingredients such as oil, copper and thermal coal will be heavily used in both.

China is not the only kid on the emerging market block, even if it is currently by far the largest. Collectively, the economies of India, Brazil, Russia and Mexico are still larger than that of China. And by 2020, India, in particular, will be adding significant annual increases to the quantum of demand across a whole range of commodities. It will roughly be where China was in 2000, when the first leg of the Commodity Supercycle began. This will mean those commodities that benefited from China's consumption, especially iron ore, ferrous metals and metallurgical coal, will experience revivals as the next tier of emerging giants go through the same industrialization process as China has recently done.

For investors, the near future is not, however, to be 2000-2008 reheated. This first course of the Commodity Supercycle was a dish that pleased many tastes, especially for those playing the easy game of piggybacking their investments onto rising prices. The main course is going to be not only a more substantial dish, but a subtler one too, requiring a more sophisticated palate to appreciate. Investors focusing more on volume and cost efficiency rather than hypnotized by price will be the real winners in this era.

Consequently, companies that investors will favor should also be different, both in terms of their strategic composition and their geographical makeup. No doubt there will be winners common to both courses, especially those large well-diversified companies like BHP and RTZ. These companies are built on the principle of exploiting the magic dust of capitalism, volume gearing, as they are able to produce large quantities of products at very low cost.

Other attributes to look out for will be those companies that do both mining and commodity trading - like Glenstrata and Noble & Co - as well as those companies that evolve their commodity profile in line with the changing tastes of China as the producer versus consumer mix of its economy gradually moves in favor of the latter. The coming era will be one in which, for instance, those companies involved in agricultural -specifically food - commodities prosper. Finally those companies with strong balance sheets that can acquire financially stranded companies sitting on large undeveloped oil and mineral deposits will also benefit.

One of the most interesting groups of likely winners are those companies from the emerging world whose names are not yet familiar to global investors. Beyond the well-known Chinese, Russian, Brazilian and Indian oil and mining companies, there are a host of players from other emerging markets, such as oil companies like PTT of Thailand, Ecopetrol of Colombia and Pertamina of Indonesia to watch.

It is not just companies that will be winners (and losers) in this era, but countries too. Regionally, virtually every nation in the southern hemisphere stands to prosper but only if it follows the right mix of policies, by far the most important of which involves supporting the building up of their volume of oil and mineral production to facilitate large scale exports at low cost. Countries whose governments invest or even co-invest with the private sector in expanding infrastructure (like ports, rail and pipelines) are the most likely to succeed.

By contrast, countries that thwart output expansion and instead try to kill the geese that are laying their golden eggs - through excessive royalties, misplaced insistence on local beneficiation or other behavior akin to resource nationalism - will do far less well. All these countries would be well advised to focus their efforts on avoiding the ravages of Dutch Disease by managing their exchange rates, building up sovereign wealth funds and transferring at least part of the windfalls accruing from the commodity bonanza from this generation to future generations.

The author is an investment strategist with Invetec Asset Management, a South Africa-based financial products company. The views do not necessarily reflect those of China Daily.

(China Daily 03/08/2013 page7)