Friday, December 30, 2011

Commodities: Look Out!

The forecast for mining companies in 2012 is that they will make record profits. Is that the kind of backdrop in which you should invest in this space? Probably not!

High prices for commodities (the assumption that underlies these profit forecasts) erode demand (by encouraging substitution, a reduction in consumption etc.) while encouraging supply (mining companies are growing like wildfire). As a result, commodity companies should not be able to generate incredible returns on capital for long.

But consider the estimates for certain commodity giants, like Barrick Gold. The analyst consensus net profit forecast for Barrick in 2012 is $6 billion (up from $4.7 billion this year), which would give it an ROE of about 27%. It's return on tangible book value would be a ridiculous 48%. This is certainly possible, but probably not something you want to be relying on as a sustainable scenario.

Another headwind facing commodities is the potential deflation (or pop) of the Chinese real estate market. China currently imports more of several commodities than does the US, even though its economy is less than half as large. While commodity prices have been buoyed by this Chinese demand, this level of consumption is probably not sustainable.

Value investors that believe in this thesis should be sure not to just worry about companies directly tied to commodities, but also those that could be indirectly affected. For example, the earnings estimates of companies supplying equipment that is primarily used by miners also rely on assumptions about commodity prices that may prove optimistic!

Invest within your circle of competence. If you don't fully understand the supply/demand dynamics of a commodity (or any) product, you should avoid relying on assumptions that could burn you.

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