MacKenzie B. Davis has been a member of RS Investments' value and hard assets teams since 2004 and has been involved in the management of RS Global Natural Resources since 2005. He recently answered our questions on deflation and its potential effect on natural-resources investments. He also discussed taking advantage of commodity price volatility and which of the fund's holdings he is most likely to own for the next 10 years.
1. As more investors become convinced that deflation, not inflation, is the prominent threat, what impact do you foresee on the performance of natural-resources investments? Is the case weakened?
When debating inflation/deflation, it is important for investors to differentiate between the outlook for commodity prices, which we contend is positive, and the outlook for finished-goods pricing, which is more challenging. In addition, there are unique returns available to natural-resources equity investors which are not dependent on rising commodity prices. The combination of these two factors makes a continued and compelling case for including an actively managed natural-resources strategy in a diversified portfolio.
Based on years spent in the field visiting projects around the world, we remain constructive on the long-term outlook for commodity prices for two reasons. First, spare capacity is relatively limited, the result of underinvestment in new production in the 1970-2000 time frame combined with increases in demand from emerging markets. Second, most commodities face rising marginal costs of supply, meaning that the next increment of production available for extraction requires ever-higher prices to generate economic returns. Because natural-resources assets are finite, each unit of production must be replaced, even in a no-growth economic environment. Thus, we expect long-term prices to continue to trend higher. Short-term prices will likely remain range-bound with a high degree of volatility until global demand begins to increase on a more sustainable basis. Deflationary concerns rest largely in the world of finished goods, where excess labour, housing, and manufacturing capacity limit pricing power.
More importantly, however, is our view that certain natural-resources companies can create value even in a flat- to low-commodity-price environment. Stripping out commodity prices, our research shows that low-cost advantaged producers have historically increased intrinsic value 10%-20% per year aftertax across a commodity-price cycle. This value compounds to the benefit of long-term shareholders and is the return stream we attempt to capture for our investors. Because we do not believe that we can consistently and accurately predict short-term changes in commodity prices, we view any increases in price above our assessment of the marginal cost of supply as the cherry on top.
To summarise, the long-term outlook for commodity prices remains constructive, in our view, though we acknowledge that a return to a more robust price environment requires a coordinated global economic expansion. Like most others, we have no idea of either the timing or magnitude of such a development. For investors seeking returns that have historically compounded at 10%-20% per year across a commodity-price cycle, with a free option on commodity-price exposure as a means to combat inflation if and when it emerges, an actively managed natural-resources strategy can be an attractive investment option. For investment strategies which rely more heavily on capturing beta--in this case rapidly rising commodity prices--the investment case is more challenging.
2. With the proliferation of funds that provide exposure to natural resources and commodities via nonequity means such as futures, what do you see as the key advantages of a fund like yours, which prefers making direct equity investments?
There are three primary ways that investors can gain exposure to natural resources and commodities: via natural-resources equities, commodity futures, and physical ownership of the actual commodity. Of the three, we believe that actively managed natural-resources equity strategies offer three key benefits: leveraged exposure to long-term commodity price trends, the ability to gain access to a broad array of commodities, and company-specific value creation. I will briefly examine the investment options and their individual sources of returns.
Natural-resources equities can potentially provide exposure to three return streams. First is the fact that the corporate structure provides leveraged exposure to commodity prices. This can be attractive when prices are rising and of course less attractive when commodity prices correct, which is inevitable. Second is the fact that natural-resources equity investors can gain access to a broad array of commodities which are not traded on futures exchanges. Commodities such as metallurgical coal, iron ore, and potash have attractive industry structures, while others such as salt, aggregates, and industrial gases offer unique inflation-protection characteristics. Finally, and most importantly, are the returns generated by what we call advantaged assets.
Our research shows that low-cost assets, both in terms of their capital intensity and operating costs, which sit at the bottom of a steeply sloped supply cost curve, historically have generated aftertax annualised returns of 10%-20% across a price cycle. A steeply sloped supply cost curve protects the advantaged asset because high-cost producers are forced out of the market well before prices undermine the low-cost assets' economics. In fact, our analysis of advantaged assets shows that they earn above-cost-of-capital returns at every point in a commodity-price cycle, allowing these companies to increase intrinsic value independent of commodity prices. This value can, in turn, compound over time to the benefit of long-term shareholders, all without having to accurately and consistently speculate on the direction of short-term commodity-price movements. By simply extending their time frame, investors may be able to have access to a persistent economic-return stream which provides the characteristics of real asset allocation in a far lower-risk manner than most strategies in the natural-resources and commodities markets.
For investors in commodity futures indexes, returns are a function of a three-part equation: spot prices, roll yield (related to the shape of the futures curve), and interest earned on collateral (typically short-duration bonds or Treasury Inflation-Protected Securities). Historically, the vast majority of futures returns have in fact been generated by interest on collateral which, in the context of deflationary fears and a 150-basis-point yield on 10-year TIPS, may not be very attractive going forward.
More recently, positive spot-price returns have been almost entirely offset by negative roll yield, which occurs when future commodity prices are higher than current ones. This is known as contango and has been an increasingly common phenomenon in the commodities market, particularly during the last 10-15 years. We contend that the futures curve is discounting higher future prices because of limited spare capacity and rising marginal costs of supply. It is ironic that the factors which have created so much interest in the space have generated negative returns for investors in commodity-futures strategies.
Physical ownership of commodities, the third way to gain exposure, is a rare option, particularly with gold, though the option is becoming increasingly popular. The source of returns is straightforward: increasing spot-commodity prices less costs related to storage and security.
Commodities do not create value; they simply go up and down in price. In addition, the data shows that in aggregate, commodity-producing companies do not create value, either. Any return is simply a function of changes in commodity prices. The lack of value creation helps explain why actively managed natural-resources equity strategies have often generated superior returns versus the commodity, commodity-futures, and passive-equity strategies during the last decade. Our strategy attempts to identify those few companies across a broad array of both exchange-traded and non-exchange-traded commodities which own advantaged assets, and then we would purchase them when valuations provide us with what we view as a sufficient safety net over our investment time frame. By doing so, we seek to capture the growth in intrinsic value discussed above, while providing exposure to commodity beta for free.
3. How do you take short-term commodity-price movements into consideration when making investment decisions for the portfolio, and how do you take advantage of price volatility?
We view commodity-price cyclicality as both the biggest risk and biggest source of opportunity in the market place. It is important to understand why prices oscillate before we explain how we attempt to manage and take advantage of short-term volatility.
Commodity-price volatility acts to balance supply and demand. Prices cannot sustainably go below the cash cost of production because supply is rationed when high-cost producers generate negative cash flows. On the other hand, prices cannot stay much above the price where demand is destroyed before consumers change consumption patterns and prices drop. Prices oscillate around the marginal cost of production, which is the price required for the next increment of supply to earn an economic return on capital. Over time, prices must return to the marginal cost of production because each unit that is extracted and consumed must be replaced, even in a no-growth demand environment.
Based on our project level work, we believe that we can quantify cash costs and the marginal cost of supply for each commodity. The price of demand destruction typically is clear solely with the benefit of hindsight and is relevant only if you are attempting to forecast how high prices can go. We view prices meaningfully above or below the marginal cost of supply as being unsustainable during our investment horizon, acknowledging that the timing of a demand correction or supply response is difficult to predict.
Our valuation work is based on our assessment of the marginal cost of supply for each commodity. We build discounted cash-flow models for each project that a company owns and then aggregate them to a corporate net asset value. We purchase businesses when we can buy them at our calculated view of a discount to proved-only NAV so that we can establish what we view as a safety net. As a result, we believe that we get both commodity-price exposure and future value creation for free.
During short periods of time, stocks, and commodities are highly correlated, with changes in commodity prices explaining as much as 80% of stock-price variance. During a three- to five-year time frame, however, changes in commodity prices have a limited impact on differentiated investment returns, which are almost entirely a function of company-specific value creation. With an average holding period of approximately six months, it is clear that the market is much more focused on capturing the beta related to commodity-price changes. Thus, in our view, the returns associated with long-term value creation tend to be mispriced.
By managing a strategy which is highly diversified across commodities, we believe that we can use commodity-price volatility both to manage commodity-price risk as well as take advantage of market inefficiencies. We use periods when the market is bearish on a given commodity--that is, when stocks are discounting a commodity price below the marginal cost of production--to establish positions in the few companies that are able to generate attractive rates of return even in a low-commodity-price environment. As a result, we seek to provide our clients with exposure both to a return to midcycle pricing as well as future value creation. We use periods when the market is overly constructive on a commodity--such as when stocks are discounting a price materially higher than the marginal cost of production--to reduce our positions in those same advantaged assets because by owning them we feel that we are exposing our investors to unsustainably high commodity prices. In summary, we believe that our time frame and investment process allows us to exploit short-term volatility as a means to manage commodity-price risk within the portfolio and to enhance returns to our investors.
4. Among the fund's holdings, which ones are you most likely to own for the next 10 years, if any?
We invest for the long term and seek to own companies with advantaged assets and the ability to compound value through multiple commodity-pricing cycles. As a result, many of what we view as our best investments are the ones which we have owned for many years and which we intend to own for many more.
Although it's impossible to predict which specific companies we will own during the next 10 years, the track records of companies such as Southwestern Energy, Goldcorp, Compass Minerals, Antofagasta, and others suggest that potentially owning these assets for long periods of time, as opposed to speculating on short-term changes in commodity prices, generates materially superior risk-adjusted returns for shareholders.
For us to own a natural-resources company, we must answer two questions. One, can the company continue to increase intrinsic value absent an increase in commodity prices? Two, do we have what we view as a sufficient safety net such that the probability of capital loss is limited during our investment time frame?
One of the most unique features of the natural-resources space has to do with the persistence of competitive advantages. For most industries, companies with an economic advantage, such as a new product or a larger factory, are faced with a competitive response from the market place, which tends to force returns on capital to mean revert over time toward the cost of capital. In the natural-resources market, competitive advantage is primarily a function of the asset quality that a company owns. Put another way, a commodity-producing company's ability to earn above-cost-of-capital returns is largely determined by where its assets sit on the supply cost curve of that commodity, which in turn is the result of geology that was established hundreds of millions of years ago.
The competitive advantage is the rock, and the rock typically isn't changing. This lack of mean reversion of returns is what has allowed low-cost, advantaged commodity producers to generate compounded annual returns greater than 25% for 10-15 years. Not only are these companies advantaged commodity producers, they are some of the best business models available in the global equity market place. Once we have established a view that a company owns advantaged assets and has an inventory of projects to develop which will allow it to remain in the bottom of the supply cost curve, we believe that we have addressed its ability to compound NAV without having to speculate on increases in commodity prices.
When examining valuations, we define "valuation" not in terms of how much money we might make, but rather in terms of the value of the asset today, relative to the available price. When we can purchase an advantaged asset at a discount to our assessment of its current value, we feel that we have established the proper safety net to protect our investors' capital. To the extent that the company's economic value increases at least as fast as the share price, our safety net remains in place. As a result, many of what we view as our best investments are ones which we have owned for many years and which we intend to own for many more.
Overall, we run a portfolio that is broadly diversified across commodities and highly concentrated around the few advantaged assets in each commodity, with relatively low turnover. We know that we can't call short-term movements in commodity prices. Therefore, we focus instead on identifying which assets create value over time and wait for the market to provide us with a purchase price that doesn't expose our investors to unsustainably high commodity prices and that doesn't require us to pay for future value creation.
5. Is BHP Billiton a play on China, and if so, what are the macroeconomic factors you're watching to monitor your thesis?
Producers of global commodities, such as BHP Billiton, have clearly benefitted from the rapid growth in demand from emerging markets, including China. For investors in the natural-resources space, improvements in supply-side fundamentals related to reductions in spare capacity as well as rising marginal costs of supply are perhaps more important.
As it relates specifically to BHP, we view it as a play on an owner of large, low-cost assets in commodities such as metallurgical coal and copper, where costs curves are steep and steepening, as well as a dominant position in iron ore, which is highly consolidated and where infrastructure constraints keep the cost curve from flattening as quickly as it might otherwise. In our view, the company has historically done a good job allocating capital and is one of the few large-cap companies to have compounded NAV on a debt-adjusted per-share basis during the last decade.
We monitor inflationary pressures and changes in demographics and try to identify major structural imbalances, but for the most part we acknowledge that correctly predicting demand cycles is extremely difficult. In addition, speculating on inflection points in demand is more useful for investors trying to call short-term changes in commodity prices. We focus instead on understanding supply cost curves, which we can calculate empirically.
We recognise that our approach may cause us to underperform relative to others who correctly call fluctuations in demand. Over time, the cyclical nature of commodities tends to balance out, and the investment results that are generated are primarily a function of company-specific value creation. That is why we believe that measurement periods are so important for investors in the natural-resources market. In our view, unless you are measuring results across a commodity-price cycle, it is easy to confuse beta related to rising commodity prices with alpha that the manager or the portfolio companies generate.
