Monday, May 16, 2011

Commodity Bubble

Well I haven't had much time lately to post but thought I would stop and share a few thoughts.  I was about to write an article a few weeks back with the same title but Goldman Sachs beat me too it.  They made the call that oil prices were bound to fall and that they have.  UBS securities has subsequently put out a much more thorough piece on the unwinding of the short dollar/long commodities trade.  Beyond this I will share a few ideas about where I currently see value despite the pain that is bound to come in the commodity sector. 

Commodity Bubble

One question that seems to constantly be bothering me is this.  If the low interest rates from the Alan Greenspan era helped ignite the housing bubble, in what areas today are the even lower interest rates potentially causing a bubble?  The only area I really see trouble is commodities.  I often look in the rear view mirror and see what has done well the past few and try to avoid it (and similarly I look at what has done the worst and look for bargains).  Commodities have definitely done well the past decade. 

Warren Buffett has said he learned an important concept from Ben Graham  that I have never and will never forget.  It is this, "you can get into far more trouble with a sound premise than an unsound premise because you'll just throw out the unsound premise."  At my work, senior management has placed a strong emphasis on critical thinking and I think the single largest principle I have learned through the process is to carefully examine everything you believe.  Our biases obviously play a crucial part blurring our thinking but our innate egocentric nature can also play tricks on us.  Of course we believe what we believe to be true... for why would we want to believe a lie?

To make this complex topic a little clearer I will use an example.  I have seen many bloggers post that oil prices only has one way to go and that it up.  The thinking is something along the lines of supply is maxed out and demand is ever growing.  Now this sounds good but may or may not be true, no one knows for sure.  It may be egocentric thinking blurring our reasoning and the person wants to believe it is true because it is in their selfish interest to believe it to be true (Innate Selfishness).  This is why constantly questioning your assumptions is important and why Buffett has said sound premises can get you into trouble. 

I recently read that the CEO of Exxon Mobil said that if the price of oil sold for the marginal cost of production, that is the cost to find the next barrel, it would sell for between $60-70 per barrel.  So where will oil be in a years time?  I have no idea, but I do know what the cost of a marginal barrel is and that will act somewhat like gravity on the price of oil.  This is why Warren Buffett called it a mistake to purchase ConocoPhillips when oil was selling for $140/barrel.

So what about other commodities compared to the marginal cost of production?  Well, copper for instance sells for close to $4/lb and it's marginal cost is $1/lb.  Gold is another example selling for $1500/oz and we can dig it out of the ground for $450/oz (only to foolishly put it back into the ground a Fort Knox).  Clearly many commodities are selling for many times the marginal cost.

China

Here is where things get interesting.  Many point to the sound premise that China is consuming vast amounts of commodities and thus their prices are only going to go to the moon.  This may or may not happen but one thing is becoming more and more clear is that China is in a real estate bubble.  I have now seen far too much evidence of this and believe things are getting out of hand.  I have heard an account of a school teacher who owns 3-4 properties and could sell out for a handsome sum today but doesn't want to.  Why you might ask?  Because she sold one a property two years ago and prices have doubled since then.  Now if that doesn't sound like the USA around 2005 I don't know what does.

If we step back and look at the macro side of things, commodities could be in for a world of hurt if China starts to stumble.  The consume 48% of the world's production of iron ore, 47% of the production of coal, 45% of the production of steel, and 39% of the production of copper.  Secondly, investment makes up 70% of GDP and consumption the rest.  This level of investment is unheard of and is why renowned short seller Jim Chanos is short China.

Here is a very interesting article discussing on the topic and how the USD will appreciate.  The UBS article is also a good read..  The end of QE2 may spell the end to the commodity bubble as capital starts for flow back toward the USA. 

http://blogs.forbes.com/afontevecchia/2011/05/13/commodity-correction-will-last-all-summer-as-massive-carry-trade-unwinds/?partner=yahootix

Stocks on Sale

If one is looking for bargains in this market, I believe the following offer decent value. 

Warren Buffett commented at his annual meeting that Microsoft (MSFT) is cheap but he is restricted from buying because of his ties to Bill Gates.  I doubt he would buy anyway.  Microsoft's stock has gone nowhere for 10 years and it's P/E has gone from 50 to under 10 times after tax earnings.  The company is a cash generating machine.  I like the company but it's recent move to buy Skype for $8.5 billion is definitely a head scratcher.  That price is something like 10 times sales and 32 times EBITDA.  I will give Bill Gates the benefit of the doubt as he is a smart guy, but as many other people have commented... this purchase is equivalent lighting $8.5 billion in cash on fire.  I don't know, Microsoft is well run and many laughed a few years back when Microsoft entered the video game business and lost money doing it for several years.  Today the Xbox is very popular and gaming contributes 13% of Microsoft's sales. 

I also also like Goldman Sachs (GS) at 1.2 times tangible book value.  Today uncertainty is definitely weighting highly on the shares but they are doing well given the climate.  The company is the premier investment bank in the world and it is selling cheap.  Similarly, Wells Fargo (WFC) has also moved back to where it was in Q3 last year when Warren Buffett was busy buying the stock.  I have written on the company before, they are a money making machine.  Another interesting aside on Wells is that they really seem to be making a push into insurance.  The annual report highlighted a number of small acquisition they have made into this area. 

Finally, Berkshire Hathaway (BRK.A) is selling on the cheap.  It is a company I currently do not own but may in the near future.  To break down the valuation, the company has $94,730/share in investments and operating earnings per share before taxes (EBT) of $6000/share.  Whitney Tilson has suggested Warren Buffett uses a 12 times multiplier on the EBT, and thus the intrinsic value is in the neighborhood of $167,000/share.  Tilson then looks out 12 months and adds 5% growth in the intrinsic value and the cash build of $7000/share and comes up with a valuation of $182,000/share a year out.  This is over 51% higher than the current share price of $120,000/share.  I would also add that that many of the investments Buffett holds are very blue chip companies who share prices have gone nowhere for the past decade.  Many of them sell for 10 times earnings adjusted for cash on hand.  Similarly, many of the companies Berkshires owns are outstanding as well. 

Beyond these Cisco Systems is a buy but I don't know the company well enough to make an intelligent decision.  Clearly the market thinks the company is in trouble but they have an impressive track record.  Over the past 10 years sales have grown 13% and earnings have grown 12% annually.  They have a huge stockpile of cash equivalent to $5/share (net of debt).  Today the shares sell for $16.60 so net of cash they are selling at 8.9 times earnings.  If anyone knows the business and has a serious analysis I would be interested, send me an email. 

Conclusion

Hopefully this wets the appetite for a while. 

While I hope the commentary is interesting don't feel it is some sort of forecast.  It is almost certain I can or will be wrong but I do believe the troubles in China are the making of a bubble that may have a dramatic effect on the price of commodities.  If anyone has an interesting perspective on how to short commodities I would be very interested, drop me a line. 

As for bargains, I present them for your entertainment but don't feel compelled to trade.  I will be examining my investments to see if I can maybe purchase some Berkshire.  The company is as of the highest quality you can find and the price is attractive.  My motto is buy right and sit tight.  Many feel like they have to jump into and out of the market, but all that does is make your broker rich.  When, not if, the China situation blows up the entire market may be quite a bit cheaper. 


Best Regards,
Kevin Graham


Disclosure - Long GS & WFC. 

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