If a global economic recovery, especially in the emerging markets, is what you believe in, then investing in resources and commodities is likely one way to take advantage of that growth. As huge segments of the population in India, China and Brazil move from rural areas to cities to earn their living, construction of houses and infrastructure needs to take place to accommodate this massive influx of people. Resources such as steel, nickel, tin, zinc are needed to accomplish this endeavor. So once again, we are thrilled to present to you a very detailed and insightful interview with a materials and metals analyst responsible for covering metal mining and steel companies across the Emerging Markets.
Luisa Moreno is a metals and mining analyst at Lusight Research, a global leader in Emerging Markets equity research. She is an engineer, holding a PhD in Mechanics and Materials from Imperial College London, UK. She has presented at numerous international conferences, and has diverse industrial, R&D, and commercialization experience. Luisa’s technical and financial insights have been vital in asset allocation decisions for top-tier institutional investors around the globe.
Q: In the near future, global economic growth seems to be stemming from the emerging markets. So how do the valuations of emerging markets companies compare to those in develop markets?
A: Emerging markets are considered riskier because they carry higher political, economic and currency risks. I normally use the DCF approach to value companies, and it is common practice to adjust for emerging markets risk by simply adding the sovereign risk premium (which is equal to the difference between the yields on a local bond denominated in US dollars and a US government bond of similar maturity) to the discount rate (or WACC). That however, is not an accurate approach, since risk premium should only reflect non-diversifiable risk – i.e. risk which is common to an entire class of assets.
Besides, we shouldn’t expect specific country risks to affect all the sectors of a country’s economy in the same way either. For instance, China recently relaxed its Yuan policy, which is expected to increase the purchasing power of the Chinese consumers and businesses and raise overall domestic demand; including demand for industrial metals. At the same time however, it will likely hurt the textile export business making the exports from poorer neighbouring countries more competitive. Thus, the best way to account for the emerging markets risk is to incorporate that risk directly into the cash flow projections by using macroeconomic, sector and individual company factors (inflation, interest rates, GDP growth, government actions, exchange rate fluctuation and the outlook for the sector and individual companies) in the forecasts of revenues, expenses, capex, working capital, etc.
Also, because macroeconomic factors tend to be highly volatile in emerging markets regions, it is imperative to run scenario and sensitivity analysis to assess the full spectrum of risks. When valuing mining and metal companies with global assets, it is important to run a bottom-up analysis, and incorporate the impact of macroeconomic factors on each mine/asset according to the region.
There are various inexpensive providers of macroeconomic forecast data; alternatively the World Bank and IMF also offer short term guidance. Another challenge for those modelling and performing fundamental analysis of emerging market companies, is the quality of the financial reporting. Fortunately Brazil and South Korea will be adopting IFRS (International Financial Reporting Standards) in 2011, and more countries are adopting the international accounting standards.
Q: Luisa, can you please talk a little bit about the political regimes and stability of countries in the emerging markets? In your opinion, which countries do you consider the most stable politically in the emerging markets and which do you consider the most unstable for investors in North America?
A: Firms investing in the emerging markets can offer the best assessment of the local political risks. A recent survey by the Multilateral Investment Guarantee Agency (MIGA) asked investors, which types of political risk are of most concern to them when investing in emerging markets. Most investors listed breach of contract as the principal political risk, followed by currency transfer and convertibility restrictions and non-honouring of sovereign guarantees. Investors listed Russia as the country with the highest political risk in the BRIC region, followed by Brazil and India. They believe that Russia has a high probability of government intervention and breach of contract, which is particularly relevant for the resources industry. The perceptions are similar for Brazil investors, but less severe.
The main concern listed by those investing in India was currency transfer and convertibility restrictions. Investors believe that China has the lowest political risk at the moment but likely has the highest risk for civil disturbances and terrorism. It is interesting to note however, within the top performing funds in the last two years were Russian focus funds and a few Brazil focus funds, which indicates that despite the risk, those investors willing to do the detailed home work can find significant risk adjusted returns in these regions.
Q: As a materials and metals analyst what are some of the trends you are seeing in the industrials metals?
A: Let me start by giving you the broad perspective of Industrials Metals market and then we can go over what is likely happening now.
The big picture for the industrial metals is very positive, with the main driver being the economic development that we are seeing in the emerging markets. In the last decade, the production and consumption of industrial metals in the global emerging markets has increased significantly. For instance, steel production in China increased from 123 mln tonnes in 1989 to 568 mln tonnes in 2009, more than four and half times in 10 years; copper production increased from 520 thd tonnes in 1989 to 960 thd tonnes in 2009.
In India, steel production rose from 24 mln tonnes to 57 mln tonnes and there are plans to reach 125 mln tonnes in the next 2-3 years. The trend, although not as dramatic, is similar in other growing economies. In contrast, steel production in the United States and Canada fell by more than 40% and copper production decreased by more than 25%, during the same period. Although consumption of steel and base metals is at an all time high in the emerging markets, the consumption per capita analysis suggest that there is still room from growth.
Economic studies suggest that industrial metals and minerals consumption depends on the stage of development, the stages are normally divided in four, and are said to be dominated by 1) infrastructure development, defined by high use of cement and construction materials; 2) light manufacture, defined by high use of copper; 3) heavy manufacture, defined by high use of aluminum and steel; and 4) Consumer goods, defined by high use of aluminum, energy minerals and specialty steels [Source: USGS]. The stages are expected to take about 20 years each and begin at 5 year intervals, lasting for a total of 30 – 40 years, depending on political and macroeconomic conditions. China for instance, appears to have entered the heavy manufacture stage based on steel consumption, while India may be well into the light manufacturing stage.
This is the big picture though and it is where the world is trending, however industrial metals are a cyclical business. They will inevitably be peaks and troughs along the way, as we go through the various economic cycles, with many long and short investment opportunities.
In the short term, the overall sentiment for metals seems to be bearish, most metals prices are down from their 2010 peak prices, e.g. copper is down 6%, aluminum 18%, Zinc 25% . Prices were up in the beginning of the year driven by the government stimulus around the globe and expectations of infrastructure spending, as that effect is fading out the economy is clearly slowing down. Some of the leading industrial metals producers expect lower production this year compare to 2009.
Arcelor Mittal (MT), the world largest steel producer expects to lower utilization rate from 78% in Q2 to 70% in Q3, as they anticipate a weak economy. Freeport-McMoran (FCX), one of the world’s largest producers of copper, expects production for this year to be 5% lower than 2009. Rusal’s the world’s largest aluminum producer, reported 14% lower alumina production, and 4% lower aluminum production in the first quarter and is cautiously raising production.
If in the next two quarters the data on building permits, construction and manufacturing activity and GDP growth in the western economies turns out weak, and if China succeeds in slowing down their economy by tightening lending to control inflation, we should see a stagnation or further depression of metal prices and stocks. However, opportunities are in the horizon and prudent investors should be on alert for potential bargains.
(Click to enlarge)
Q: Despite robust growth in China, steel demand appears to be slowing, while tin and nickel have been the best performing metals this year. What is your outlook on these three metals in terms of supply/demand and pricing outlook going forward?
A: Industrial metal prices are dependent on factors such as production costs, foreign exchange, strategic stockpiling, speculation and industrial demand. Additionally, low resource and reserves levels of a ‘in demand’ metal, tends to drive the metal price up further.
Steel is an alloy consisting mostly of iron; as such prices of iron ore inevitably tend to affect steel prices. The recent increase in iron ore prices however, was certainly not driven by low resources (there is plenty of iron ore on the earth crust), the rise in price can be mostly attributed to the estimates for capital expenditures needed in the short term to sustain future demand.
Higher raw materials (iron ore, coal, nickel, etc) and energy prices have been the main drivers for the rise in steel prices this year. However, as China attempts to slowdown its domestic growth, and US and European economic recovery weakens, we should see a slowdown in steel demand, followed by price stagnation or even a slight decline in the fourth quarter.
Nickel prices fell by more than 80% from the peak price of about US$24/lb in 2007 because of the recent global recession. When metal prices recovered in late 2009, nickel prices were still 50% below the pre-recession peak prices, while stock indices around the globe were at an all time high. Although prices have shown a good momentum in the recent months, the only reason it shows up as a good performer in 2010 is because nickel prices stayed depressed well in 2010, a much longer down period when compared to other metals. Nickel is used primarily as an alloy and in stainless steel production. It appears that the recent surge in nickel prices have been driven mainly by stainless steel demand.
Nickel is the fifth most abundant element on earth, while economically mineable reserves are limited; there is no shortage of nickel resources. The economics of nickel are highly linked to stainless steel demand, hence, as the economy slows down and steel demand weakens, we expect to see a decline in demand for nickel, and prices may fall further. However, prices are still well below the pre-recession peak levels, which may lead to higher gains if the price reaches new highs, as the economy recovers.
Tin is a highly overlooked material, approximately 80% of the metal is produced in Asia, with China and Indonesia, as the leading producers. The base metal faced supply constrains in the first half of this year. Especially from Indonesia where mine disruptions, higher operating costs and government regulations have hindered production; which is expected to decline by 20% this year. Tin LME stockpile is 50% down from Jan-Aug and prices are up by 23%, although highly volatile during this period. Over 30% of tin is used to produce a solder alloy with lead for use in the pipeline and electronics industries. Recent environmental regulations in China and Europe that target lead, requires higher use of tin over lead in soldering applications.
While that has caused a decrease in soldering quality it has fuelled tin demand, at least in the short term until lead substitutes are found. Tin is also used for packaging, and demand doesn’t seem to be slowing down. We expect tin demand to stay strong, and supply levels to improve gradually as mine expansions take place and production rises. Price growth may slow down if the economic recovery in Europe and in the US slowdowns further. However, the fundamentals for tin are relatively strong and we expect prices to rise further next year.
Q: Luisa, in your opinion what is the best way to invest in industrial metals?
A: The easiest way to start investing in industrial metals and Global Markets is likely through ETFs. There are ETFs for almost any asset class you can imagine, the trick is to find large size funds with good performance and high trading volume. Investors can choose commodity company ETFs or/and pure commodity EFTs . Commodity company ETFs invest in company stocks, some offer global exposure others only include domestic stocks.
Pure commodity ETFs invest directly in the physical commodity through futures contracts. Futures trading can be complex for the retail investor, as contango risk, storage and insurance costs, makes it difficult to turn a profit. This type of investments is usually performed by experienced investors that have the time and resources to manage such investments; as such pure commodity ETFs offer a safer alternative for those interested in investing in physical metals. I would suggest the following ETFs:
GlobalMarket Vectors Steel Index (SLX) (US$258.2 mln , Avg Vol: 211 thd), the top holdings are giant mining and metal firms, Vale (VALE) and Rio Tinto (RTP) and also includes North American firms, United States Steel Corp (X) and Nucor Corp (NUE).
SPDR S&P Metals and Mining (XME) (US$692.9 mln , Avg Vol: 3.2 mln), it includes copper producer Freeport – McMoran (FCX)and aluminum giant Alcoa (AA), but it also offers exposure to gold and energy stocks.
ETF Powershares Base Metals (DBB) (US$342.5 mln , Avg Vol: 194 thds) is a rules-based index composed of futures contracts on aluminum, zinc and copper (grade A). Also, iPath Dow Jones AIG ETF series offers exposure to individual base metals futures market, they are however less liquid.
Valuation: Measuring and Managing the Value of Companies, fourth edition. Mickinsey & Company. Tom Copeland, Tim Koller, and Jack Murrin.. New York: John Wiley & Sons, 2005
British Geologocal survey. World mineral production 2004-2008. TJ Brown et al. Technical report:A C Mickesey. NERC 2010.
British Geologocal survey. World mineral production 1999-2003. L E Taylor et al. Technical report: A C Mickesey. NERC 2005.
Absolute Returns in Commodity. (Natural Resource) Futures Investments by Hilary Till and Jodie Gunzberg. Hedge Fund & Investment Management (Edited by Izzy Nelken), Elsevier, 2006
Thank You, Luisa!