There are at least half a dozen broking firms that I’m aware of that are currently recommending that their clients buy BHP Billiton. None of these brokers can mention BHP without also mentioning the word “China” in the same sentence.
Firstly let’s note this: The revenue that BHP derives from Europe, North America and Japan is (in aggregate) far greater than what it derives from China. Secondly, the UK, Germany, the United States and Japan are all in recession. Thirdly, a significant proportion of Chinese exports end up in countries that are currently in recession.
I’m convinced that what most research amounts to is looking at what the share price of companies like BHP were at their peak and looking at what the price is now and saying “it must now be cheap”. Throw is some vague notion about demand from China and some promotion by brokers and suddenly BHP is “cheap”.
But BHP is a company that is actually extremely difficult to properly value. What do you really need to know to accurately value BHP?
You need to know what the prices of the following commodities are going to be over 2009 and beyond: Oil, LNG, copper, silver, zinc, lead, gold, coal, iron ore, manganese, chrome, aluminium, titanium, nickel and diamonds. Do you know of anyone who could accurately forecast the prices of those commodities?
When the price of a barrel of oil can fluctuate between $US147 and $US32 in the space of six months you can begin to see just how difficult it is to make forecasts for commodity prices.
There have also been truly enormous fluctuations in the prices of other commodities such as copper, lead, zinc and nickel. However, oil is the only commodity that most people take notice of because they use it on a daily basis.
What is the fair price for a barrel of oil? Do you know? How about the price for a tonne of zinc – any ideas? [If you want to have some fun, ask your broker what the primary uses of zinc, nickel and titanium are and see what they say – I’ll bet you they won’t know.]
To understand what caused BHP’s share price to reach $50 you have to understand what was actually happening in the global economy, and it’s as much about the United States as it is about China.
During the boom years (up to 2007) Americans were consuming far more than their maintainable incomes would have allowed (Americans were not alone in this; other developed countries had similar consumption levels). Additional consumption was being financed by borrowing against the appreciating value of assets (primarily the home or the investment property).
China was supplying much of the consumed goods and running large trade surpluses with the United States (and other countries). Logically, the prices of raw materials used to provide these goods increased because of this demand.
For commodity producers this was fantastic, they were able to make very large (abnormal) profits during this period. This in turn sent the share prices of companies like BHP and Rio Tinto to levels that could not have been imagined even 2-3 years earlier.
As you all know, the game of borrowing against the appreciating value of assets has come to an abrupt and very painful end. Globally, banks have significantly tightened lending criteria and house prices in many developed countries have collapsed.
Consumption will now be curtailed – there is no alternative. For BHP, this impacts not only on their customers in countries that are actually in recession, but also on China’s exports to those countries.
It should also be noted that China’s growth rate dropping 2-3% is no different to a country that was growing at 2% per annum dropping to 0% or -1%. For commodity producers exporting to China, this is a recessionary like environment in comparison to what they had previously experienced.
In my opinion the profits generated by the likes of BHP, Rio and others during the commodity boom were abnormal profits and it would be dangerous to base any valuations of these companies on the assumption that they will return to those levels of profitability any time soon.
The profits were abnormal because they were based on a demand for goods predicated on the availability of easy credit which in turn was predicated on rising asset prices. This allowed many consumers to temporarily live beyond their means. This cycle is now well and truly over and it’s not going to recur again any time soon.
I cannot forecast the prices of all of those commodities that I mentioned above. However, the very fact that this forecasting is extremely difficult to do (if not impossible) means that anyone who is purchasing shares in BHP or other mining companies is speculating that the price of commodities will return to levels something like that seen during 2007. That’s a gamble that I’m not personally prepared to take, especially when most of the largest economies in the world are in recession.
Now you may have a very different opinion to me.
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