By Scott Phillips
The China boom. The resources super-cycle. The increasing urbanisation of our world. The prices!
These are all reasons given by those who are allocating large proportions of their investment portfolios to resources.
In recent history, it’s been a profitable game. BHP Billiton (ASX: BHP) has seen its share price triple over the last 10 years. Rio Tinto (ASX: RIO) has seen a 50% increase, Newcrest Mining (ASX: NCM) has tripled, and we all know that Fortescue Metals (ASX: FMG) has seen fortune-making gains since its inception.
The percentage increase for long-term Fortescue shareholders – an increase of 49,000 per cent, according to S&P Capital IQ - is so large as to be hard to even process.
Integra Mining (ASX: IGR) is only one cent away from a tripling of its share price and Paladin Energy (ASX: PDN) is up 4,000% (even though it has fallen a long way since the highs of early 2007).
See – resources is clearly where it’s at, right? Maybe.
From rooster to feather-duster
Ever tried to drive a car by looking in the rear vision mirror? Me neither – but we can imagine the impossibility of getting far without losing some paint.
There’s a difference between understanding the lessons that can be taken from the past and blindly extrapolating the past into the future.
Learning that competitive advantage is important and debt can be fatal is different to expecting the seemingly endless dominance of film-maker Eastman Kodak to continue into the future. (Kodak went into Chapter 11 bankruptcy protection in the US in January).
It seems silly in hindsight to use Kodak as an example – after all, we saw the end coming, right? But those suggesting we extrapolate the past into the future need to have a very clear sense of when the trend is coming to an end. When does standard market volatility become the beginning of the end? When does the seemingly endless ability of a company to bounce back from bad news come to a stop?
Extrapolate at your peril
Now Kodak clearly isn’t a resources company, but those old enough will also remember the Poseidon experience from 1970. Extrapolation (and unbridled optimism) can put a large dent in your portfolio.
Extrapolation in the resources sector can be particularly damaging. Most – if not all – resources companies are '‘price takers'’. They largely sell globally traded commodities whose price is widely known and which are substitutable for any other company’s production.
Unlike branded businesses such as Coca-Cola Amatil (ASX: CCL) or Apple (Nasdaq: AAPL), there’s no brand premium, and buyers largely are agnostic as to the supplier from which they purchase.
Accordingly, profitability swings heavily on the relationship between supply and demand. Resources profits benefit significantly from an imbalance when the need outweighs the amount of product available.
The Achilles heel is that this dynamic is devastating in reverse. Should Chinese demand falter, supply grow (through new mines), or – scariest of all – both, pricing could fall a long way very quickly.
Smaller, more marginal mines may be forced to close or be scaled back significantly. That could force some companies to the wall. While a strong, well-chosen and conservatively bought company may not be pushed into bankruptcy, it’s hard to see a scenario whereby investors do well if profits fall by 25 per cent, 50 per cent or more.
And for those who say they’ll be able to get out in time, how much of their portfolio will they lose before realising the end is not just near, but here? Market timing is incredibly difficult, if not impossible. Be careful not to let bravado and false confidence bring you down.
A lesson in what can go wrong
Poseidon went from under $1 to over $250 in little less than a few months. Those who bought in as the price passed $50, $100 and $200 would have been feeling pretty good. That feeling didn’t last long, as the bubble burst. What looked like a steal at $100 suddenly looked very expensive on the way back down.
While Poseidon was as much a victim of speculation as anything, but that speculation grew on the back of a skyrocketing nickel price. When the nickel price fell, the music stopped with a thud for Poseidon and its ilk. When you can’t control the selling price, you perennially face that risk.
Foolish take-away
I’m not calling the end of the resources boom, but recent decisions by BHP and Rio to scale back expansion plans aren’t exactly bullish signs. If the boom doesn’t end, then I might forgo some possible gains. But if it does end, the losses may wipe out more than just the gains from here.
If you are going to hold resources shares, companies with lowest-cost operations are your friend, and those with any material debt your mortal enemy. Lastly, complete the trifecta with a significant margin of safety on your purchase price.
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Scott Phillips is a Motley Fool investment analyst. Scott owns shares in Coca-Cola Amatil. You can follow him on Twitter @TMFGilla. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691).