Category Archives: Investiv Daily


Facts, Fears and Opportunities in China

  • Even if China is slowing down, the growth is still excellent and the potential is huge.
  • The Chinese market is 43% down from its 2015 high.
  • Short term fears might give trading opportunities as the long term trend is a growing one.


In the last twelve months there has been a lot of talk around China with various economic forecasts and explanations which resulted in a severe negative influence on markets ranging from stocks to commodities. This article is going to give an overview of what happened in the last year, and some scenarios of what might happen and how that should influence financial markets.


In August 2015, China’s central bank (PBOC) made a move to devaluate the Yuan in relation to the dollar. The move was influenced by the government’s worry about slowing growth and to make the currency more market driven. The move created various market shockwaves and shows what kind of power and effect China has in today’s world. By the end of August, the S&P 500 fell by 12% and commodities further declined to five year lows based on fears of slowing Chinese demand. The devaluation of the currency was made in combination with quantitative easing where the aim was to stop the steep fall of the Chinese stock market. The Shanghai stock index started its steep decline in June 2015.

1 Shanghai

Figure 1: Shanghai Stock Exchange Composite Index. Source: Bloomberg.

From a multi-year perspective, it is clear that the market was in a huge bubble because it grew from 2,000 points in 2014 to 5,166.3 points in June 2015. The current level of the Chinese market is down 43% from its peak, but it is still up 50% from the 2014 levels. The PBOC intervened in order to lower the possible repercussions of a market meltdown. All of the above was mostly influenced by the slower growth of the Chinese economy.

2 China GDP growth

Figure 2: Chinese GDP growth per quarter. Source: Trading Economics.

The slower growth and a switch from a manufacturing economy to a service economy is what has made the global market tremble. The International Monetary Fund expects the Chinese economy to grow at a rate of 6% in 2016 and 2017, and a switch to a service economy is feared to lower demand for commodities. An even slower growth than expected could have repercussions similar to the ones the financial and commodity markets experienced in 2015. The last info about Chinese growth is a 6.8% increase for Q1 2016 which was considered positive news and further fueled the recovery in commodity prices, but the information from the Chinese Bureau of Statistics shows that despite quantitative easing and a stronger real estate market, Chinese manufacturing grew at a slower pace in April in relation to March. The manufacturing index was at 50.1 for April which still indicates expansion but flirts with contraction as it is close to the 50 mark.

With the exception of manufacturing, the question is not if the Chinese economy will continue to grow, but how fast it will continue to grow. As the Chinese GDP per capita increases the country loses some of the competitive advantages it had in comparison to the rest of the world but the increased development enables a different, more service oriented growth. Chinese GDP per capita is currently $7,990 which is only 14% of the US’s and shows how much potential China still has.

But, the service oriented and less construction oriented growth has severe implications. The exports of most emerging countries and Australia are strongly related to Chinese demand and therefore those markets are severely affected by any kind of Chinese slowdown, especially a manufacturing or real estate one.

3 economicst

Figure 3: Percentage of exports to China. Source: The Economist.

Australia, African countries, Middle East oil producers and South American commodity exporters are all highly dependent on the Chinese economy. As the above mentioned countries and regions are big enough to influence the global markets, every investor should keep an eye on what is going on in China.

Short and Long Term Forecasts

It is important to look at China from an objective perspective and not in comparison to what happened in the last 25 years. Growth rates higher than 10% are much more easy to reach when the starting point is low like it was for China. As the economy grows, the global competition kicks in and levels economic growth. The current situation is one where exports are lower, bad loans are rising, and the industrial sector is at its weakest since 2009. Capital outflows in 2015 were $1 trillion and the PBOC is trying to limit the damage by injecting fresh capital into the market.

At the same time industrial and structural trends are turning against China.

4 trends

Figure 4: Chinese industry trends. Source: OECD.

As shown above, industrial output growth has declined from 9% to the current 6%, manufacturing investing has fallen and state-owned enterprise profits are falling. This in combination with the negative demographics where the Chinese working-age population is shrinking due to the one child policy, which does not paint a rosy picture. But the forecasts are all still indicating growth, albeit a slower one. Also the demographic fears should reflect on the Chinese economy only in the very long term; currently 47% of the population is between 25-54 years, thus in prime productivity.

The government targets a growth rate from 6.5% to 7% and has planned the highest budget deficit in the last 25 years which should help the economy. The IMF forecasts Chinese growth at 6.3% in 2016 and 6.0% in 2017, while the OECD forecasts 6.2% in 2016. Not to forget that even if the economy will grow slower it will still grow. A growing Chinese economy can only benefit the global economy and markets. Therefore, the question is not if China will grow or not but how much imbalance it will create in financial markets in relation to it over performing or underperforming expectations. In any case, as a well-diversified portfolio should have some assets in the soon-to-be World’s biggest economy, below are some ideas on how to invest in China.

Chinese Investing Opportunities

One way to be exposed to China is to buy stocks of companies that have a strong exposure in China like Alibaba, Baidu or China Life Insurance that are traded on US markets. The list of Chinese stocks traded on US markets can be found on Nasdaq. A warning here, Chinese accounting and the Chinese securities and exchange policies might vary from US ones and deeper scrutiny is necessary to understand what is really going on in the business represented by the stock. Another opportunity to invest is through ETFs.


Even if China is currently experiencing a slowdown in growth it is almost certain that China will continue to grow in the short term and in the long term. A well-diversified global portfolio cannot miss out on such a growth potential. The Chinese GDP per capita has to grow 7 fold to reach the US GDP and the Chinese seem determined to grow at all costs. If the market has reached its bottom depends mostly on the short term news on Chinese growth and there lies the risk of investing in China, it takes a lot of courage to invest in a market that is more than 40% down in the last year, but such markets also create the best opportunities. For anyone more interested in trading short term, expectation misses in Chinese performance might give good trading opportunities as the underlying long term trend is a growth one.



Monetary Policies – US, Europe, Japan and China

  • Central banks hesitate to increase interest rates.
  • Monetary easing does not manage to fuel inflation.
  • If inflation arises stocks should be the best protection.


The central bank of a country determines the base interest rate at which it gives loans to banks who add a risk premium and give loans to corporate and private customers. The base interest rate is therefore the primary factor for the stimulation of economic growth and reach of target inflation.

In the US, the FOMC (Federal Open Market Committee) meets every 6 to 8 weeks and the market and journalists anxiously expect its decisions and outlook on interest rates and the economy. The same meeting schedule applies for the ECB (European Central Bank) monetary policy meetings. The BOJ (Bank of Japan) decides on interest rates in Japan and the PBC (People’s Bank of China) sets the interest rates in China.

The current interest rate in the US is 0.5%, in Europe it’s 0%, in China it’s 4.35%, and in Japan it’s negative with -0.1%. If the economy is weakening the central bank steps in and lowers the interest rate in order to promote more lending that should lead to economic growth. Those should be the reasons behind interest rate changes, however in 2015 the PBC had lowered its interest rate 5 times in order to prevent the Chinese stock market from falling further.

1 chinese interest rate cuts

Figure 1: Chinese interest rate cuts in 2015. Source: Bloomberg.

The BOJ brought its interest rate to negative in order to prevent a looming recession, but in Japan’s case the low interest rates have not fueled economic growth. Yes, a negative interest rate means that the bank is paying to lend money to banks, as strange as it might sound, it is the truth.

2 japanese interest rate

Figure 2: BOJ interest rate from 1976 to 2016. Source: Trading Economics.

The US is the first major country that is starting to raise interest rates as its economy seems to be doing better.

us interest rate

Figure 3: US interest rates. Source: Trading Economics.

It is important to see how this effects the market in the short and long term.

The Last FOMC Meeting and the Implication for Markets

The FOMC met for a two-day meeting on April 26, 2016 and left interest rates unchanged. The other important takeaways are that labor market conditions have improved further even as economic activity appears to have slowed. Inflation is still running below the 2% target.

Concerning the outlook, the FOMC expects that with gradual adjustments in monetary policy the labor market should remain strong end economic activity should improve at a moderate pace. It also expects that the interest rate is going to remain below expected longer run levels.

The implications for investors should be the following and unfortunately all the implications are double-edged swords. A further increase in the base interest rate would:

  • Strengthen the dollar as global capital flows would be looking for higher yields with low US risk. A strong dollar, as is already the case, makes exports more difficult and therefore lowers corporate revenues, which implies a return to lower interest rates if the economic consequences are too severe.
  • Increase the cost of capital for companies that would consequently lower their earnings.
  • Increase returns on bonds, and consequently expected returns on stocks. If expected returns on stocks increase the price usually goes down which reignites the downward economic cycle.

The above examples demonstrate just how difficult it is to set the correct interest rate. Interest rates that are low for too long should create inflation but the ECB, BOJ and FOMC have failed to reach their target of 2% inflation with the current prolonged low interest rates. This proves how the standard economic theory is failing in the explanation of the current global monetary and financial situation and there is no precedent on which to base estimations. Seeing how active the central banks are in supporting the economy and financial markets, it is plausible that the economic standards of the 20th century do not apply to new circumstances. A very important part for the application of the classical economic theory that is missing is inflation.

4 us inflation calculator

Figure 4: US inflation. Source: US Inflation Calculator.

Surging inflation above 2% would quickly prompt the FOMC to increase interest rates in order to prevent higher inflation rates. With higher inflation rates, stocks should perform well as higher prices increase revenues. Stocks are usually considered hedges against inflation. Bonds should be the worst performers as with higher interest rates and inflation, yields go up and bond values decline.


On April 28 the Bureau of Economic Analysis reported that the US GDP growth in Q1 2016 was the slowest in the last two years. This slowdown also explains the FOMC’s reluctance to increase rates at a faster pace. The reason behind the slowdown is a deceleration in consumer spending and a decline in business investments. It will be important to see if this is the start of a trend or GDP will bounce back in Q2. Also, it’s important to note the fact that as more data becomes available the GDP figures can be revised.

The BOJ and ECB

The BOJ surprisingly did not increase its stimulus for the economy as it needs more time to assess the effect of negative interest rates.

In Europe the policy makers are more eager to improve things as soon as they can. The European Central Bank (ECB) announced last Thursday that it is ready to use “all instruments” available, including further key interest rate cuts plus more quantitative easing.


The above is a lot of information to digest and there is no truth or rule that can help the individual investor. Monetary policies and macroeconomic trends are difficult to forecast and even more difficult to time.

The willingness of central banks to ease monetary policy at the first signs of slowing economies gives a certain perception of security. Until inflation kicks in, the banks have no limits to their easing potential and can fuel slowing economies and declining markets. If inflation does kick in the best hedges should be stocks as corporations can pass on the increasing costs onto the consumer. The financial markets and monetary policies have always been and always will be cyclical. It is up to the individual to assess how much volatility she or he can handle.



An Analysis of the Latest Earnings Reports

  • “Sell in May and go away” doesn’t sound so foolish anymore.
  • The Dow Jones Industrial Index average revenue has declined by 4.1%.
  • High liquidity and employment enables buybacks and pension funding that keep the market at high levels.


Recently there have been some surprising earnings debacles. This article is going to elaborate on them and discuss possible reasons and consequences of the earnings misses.

Summary of Earnings

Apple (NASDAQ: AAPL) reported Q2 EPS at $1.9, missing analysts estimates by $0.1 and a revenue decline of 12.8%, also missing estimates. It guided to lower Q3 revenue of $41-$43 billion which is also below estimates of $47 billion.

In spite of declining revenue AAPL continues its buyback program and increased it from $140 billion to $175 billion. By buying its own shares, AAPL is investing in a company with declining revenue and earnings instead of focusing on growth and development. Only the future can tell if AAPL will manage to turn things around and increase revenue or the buyback strategy is the only plausible strategy for AAPL’s management in order to increase EPS. In the meantime, AAPL’s shares were down 9% after the release.

Alphabet Inc. (NASDAQ: GOOG) also missed expectations with revenue growth of “only” 17.4% y/y and EPS of $6.02. GOOG spent only $2 billion on buybacks in the last quarter. Not much when compared to AAPL’s $6.6 billion for buybacks and $2.9 billion for dividends. The above represent two different strategies and focuses. GOOG’s shares were also down 7.3% after earnings.

Another company in the digital world that has seen shares plunge soon after the earnings release is Netflix. Netflix (NASDAQ: NFLX) reported revenue growth of 24.8% y/y and positive earnings per share but the slower than expected growth in subscribers influenced a 15% stock price decline.

The same happened to Twitter (NYSE: TWTR), revenue grew by 36.4% but shares declined by 9.2%. Microsoft (NASDAQ: MSFT) was also down 10% after earnings.

Before moving away from the digital sector, I’ll mention that the S&P 500 was mostly flat while the above companies sustained large losses.

In the financial sector Bank of America (NYSE: BAC) has seen revenue decline by 8% and earnings in-line. American International Group (NYSE: AIG) posted a loss of $1.1 per share but nevertheless increased buybacks by $5 billion and increased its dividend by 14%. Goldman Sachs Group (NYSE: GS) reported a decline of 55% in earnings and a 40% decline in revenue.

The above earnings reports and management actions do not create a positive sentiment. The digital companies like NFLX or social platforms like TWTR are still growing but at a slower rate, the oldies like AAPL and MSFT are not growing anymore and the financial sector is also facing strong headwinds.

In order to see how the market is doing in general—and not to focus on the companies mostly analyzed in the news—a good representation of the market is the Dow Jones Industrial Average Index (DJIA). The below table shows quarterly revenue growth from the 30 companies that constitute the DJIA.

company data

Table 1: DJIA revenue growth per company.

Of the 30 companies in the DJIA 5 companies still have to report earnings and 12 have reported declining revenues, while of the 13 reporting revenue growth only 6 of them have seen revenue grow at a rate above 2.2%. The average revenue decline was -4.1%. With such a strong decline in year on year revenues a similar decline in the Dow Jones index would not be surprising. But what is surprising is that the DJIA has risen 1.8% in the two weeks of the earnings season.

dfow index

Figure 1: DJIA index in the last two weeks. Source: Yahoo Finance.

A reason for the DJIA rising could be that the IRA contributions deadline was on April 15. As the US employment rate is still high and the interest rates are low there was plenty of liquidity to fund pension contributions and consequently the stock market.

unepmloyment rate

Figure 2: US unemployment rate. Source: Bureau of Labor Statistics.

But with declining corporate revenues, management might focus on cost efficiency by laying off employees. Up until now, corporate revenues have been constantly increasing and the consequence was increased hiring. The opposite should happen if the revenue growth trend reverses as the first indications show.

sp 500 sales

Figure 3: S&P 500 Revenue. Source: Multpl.

The previous decline in corporate revenues from the 2008-2009 period had a severe influence on the unemployment rate bringing it up to 10%. Also it was a sharper decline in revenues than the current one, accompanied by a stronger decline in earnings and without quantitative easing.


The high market liquidity influenced by low interest rates enables companies to finance themselves cheaply and reinvest that money into buying their own shares and thus skewing real ratios. A low unemployment rate means that contributions to pensions and financial institutions are high and those can keep the market up, even with revenues declining. But, the declining revenues make the following rule of thumb an interesting perspective:

Sell in May and go away.

FBN Securities researched on how the unwritten rule performed in the last 20 years and the results show that the above rule is surprisingly accurate.

sell in may perfromance

Figure 4: S&P performance by month. Source: FBN Securities.

Returns on being long in May are negative while returns related to the colder months of the year are very positive. As it is very difficult to time the market and very easy to be wrong when selling in May, the above rule of thumb should be taken with a grain of salt. But, seeing that revenues are declining, and declining revenues will eventually have an impact on the economy, it might not be a bad idea to rethink portfolio allocations and risk exposures.



The Buyback Conundrum

  • Buybacks should increase shareholder value, but that’s not always the case.
  • From a book value perspective most companies are destroying value.
  • From a return on investment perspective the logic behind buybacks is open for discussion.


The goal of investing is to enjoy stock price appreciation and dividends, but there is another method for achieving interesting returns: buybacks. With stock buybacks, a company buys its own stocks on the open market. As a public company cannot fully own itself, the purchased stocks lower the number of outstanding stocks and increase the relative ownership of the remaining stockholders. In other words, the company is using its cash to invest in itself.

If a company invests in itself, what has to be calculated—and often is not—is the return on that investment. This article analyzes the mechanics and motivation behind buyback returns and the real effects on investor returns.

The Motivation Behind Buybacks

Buybacks are usually promoted by management as the best use of capital at a specific moment. Buybacks improve financial ratios, and ratios are what analysts focus on. By lowering the number of shares outstanding, earnings per share (EPS) increases, and by spending cash, the company has less assets and equity and therefore return on assets (ROA) and return on equity (ROE) increase.

Another thing covered up by buybacks is dilution. Generous employee stock option plans create dilution, and no regular investor likes that. A good example of dilution coverage is Cisco Systems Inc. (NASDAQ: CSCO). The company spent $4.2 billion on repurchases in 2015 by buying 155 million shares at an average price of $27.22. 155 million shares on a total amount of 5.09 billion shares outstanding in 2014 would imply a nice 3.03% return to shareholders from buyback activity. But the total number of shares outstanding at the end of 2015 was not 4.94 billion, but 5.06. Thus, CSCO lowered the number of shares outstanding by a mere 38 million shares and not by 155 million like they proudly announced in their annual report due to dilution.

The Logic Behind Buybacks

If the stock of a company is really undervalued, buybacks make sense, but if the price is above intrinsic value the buybacks are questionable, or as Warren Buffett said:

In repurchase decisions, price is all-important. Value is destroyed when purchases are made above intrinsic value.

Berkshire Hathaway (NYSE: BRK) is known to buy back stocks but maximally pay a premium of 20% on book value.

1 price to book berkshire

Figure 1: Berkshire buyback activity and threshold. Source: Bloomberg.

The above 20% premium that Buffett is willing to pay does not mean he agrees to paying a premium, it relates to that fact that many of Berkshire’s investments are accounted at cost and therefore not properly reflected in the balance sheet. Think of See’s Candies, bought in 1972 for $25 million.

According to the chart below, Buffett would not agree with the principle that any buyback is a good buyback. The S&P 500 price to book value is currently 2.82 that implies an average 182% premium on buybacks.

2 sp 500 book value

Figure 2: S&P 500 Price to book value from 2000 to 2016. Source: multpl.

The question now is: are buybacks creating or destroying value? The lowest S&P 500 price to book value was recorded in March 2009 and was 1.78. Thus, according to Buffett’s logic, the bulk of buybacks should have taken place in 2009. Of course, that is far from the truth.

3 buybacks in millions

Figure 3: Quarterly share repurchases ($M) and number of companies repurchasing shares. Source: Factset.

In Q1 2009, buybacks were at their lowest with only $30 billion of stocks being repurchased. Not surprisingly buyback activity is the highest at market peaks, as evidenced by Q4 2007 when $180 billion was spent. This shows that management is not keen on following Buffett’s logic.

According to Bloomberg, a strong factor for buyback activities is that CEOs’ paychecks are based on EPS metrics (39% of it) and by buying back shares, a CEO can increase his paycheck even if sales are not growing. The focus on increasing EPS through buybacks limits the use of available cash for long term investments. Currently S&P 500 buybacks are 70% of the net income companies make, consequently only 30% of the net income is used for growth or dividends.

4 buyback and net income

Figure 4: Trailing buybacks to net income for the S&P 500. Source: Factset.

The current stock market situation reflects a fall in net income and an increase in share buybacks that is very similar to the situation at the end of 2007. This does not mean much as history is not a good predictor for financial markets, but it’s good to keep in mind.

How to Check if Value is Increased or Destroyed by Buybacks

There are a few things to check. A company should buy back shares only if that is the best investment possible. An investment is assessed by looking at its book value if you want to listen to Buffett, or by looking at the current return if you want to be more trendy. With the first option, if the company is buying back shares and paying more than book value, it is destroying shareholder value because it would be better to use that money to grow the business as the business itself is more valuable than its book value. For the second option, if the company is buying back shares and the return on those shares is lower than the company’s cost of capital, the company should be better off if it would pay of some debt.

The return on the stock is easily calculated by using the PE ratio. 100 divided by the PE ratio gives the investor’s return on the stock. For example, Microsoft (NASDAQ: MSFT) bought back stocks for $17 billion in the last 4 quarters. It’s PE ratio is 40.1 that implies a 2.5% return from MSFT’s stock. MSFT’s interest expense on its long term debt is 2.8% which adjusted by MSFT’s tax expense of 30% would be 2%, thus below the 2.5% threshold. On a book value basis, MSFT is destroying value because it is paying $50 for something that is worth $9, and on a return on investment basis, the shareholder creation/destruction dilemma can be left for further discussion.


The use of financial engineering to achieve growth could also mean that a company is at the top of its business cycle and there are no better investments than buying its own stocks.

The mania of buying back stocks resembles picking low hanging fruit. By using financial engineering management, a company can improve the required ratios and increase its remuneration. Such behavior leads to a huge and not calculable cost: the opportunity cost. A company could use that cash to do acquisitions or to invest in R&D, and who knows what good might come out of that.

Every investor should individually assess each of their portfolio components and see if the management is creating or destroying value with buybacks.



Copper as an Investing Opportunity

  • Copper has declined due to a strong dollar, increased production and a slowdown in China.
  • In the long term a supply deficit is expected as mining grades are constantly getting lower and demand is steadily growing.


Commodities in general have been in a slump for the last 5 years; the Dow Jones Commodity Index peaked exactly 5 years ago on April 26 2011. High 2011 commodity prices induced new investments that—combined with low interest rates—made it easier to finance new projects, eventually increasing supply. With limited growth in demand the inevitable result was a contraction in prices.

538 figure 1

Figure 1: DOW Jones Commodity Index. Source: S&P Dow Jones Indices.

But, commodities are known to be a cyclical business. The current low prices put off new investments and developments that limits further increases in supply and should bring to a commodity upturn cycle.

As commodity prices are mostly influenced by demand in relation to the business cycle, supply and production constraints, political issues, the value of the US dollar and investments funds speculation, those are the factors one should focus on when researching a commodity to invest in. This article will take a deeper look at how copper fits into the above picture.


Copper’s malleability, strength and conductivity make it useful in a range of building and electrical applications, and as it is found in nearly every home and vehicle, copper is the third most mined metal in the world.

538 2 figure copper prices

Figure 2: Copper prices. Source: Nasdaq.

Copper prices had been slowly falling since 2011 and further fell in 2015.

Copper Supply

One of the interesting things about copper is that many expect a looming copper supply crunch due to the fact that demand is constantly growing alongside global GDP growth, but the copper mining grades are getting lower and at current prices many of the new projects in development are not feasible.

The International Copper Study Group (ICSG) released its copper forecast for 2016/2017 back in March. World mine production is expected to increase by around 1.5% in 2016, already much lower than the 3.5% growth experienced in 2015 due to production cuts in the Democratic Republic of Congo and mine closures in Chile. In 2017 growth is expected to be 2.3% fueled by the expansion of existing projects and new mine developments.

In the longer term, there are several issues expected to limit copper supply. The first issue is that it takes more and more time from a discovery to actual production due to geological, environmental and political challenges. An example of that is the Oyu Tolgoi mine in Mongolia owned by Turquoise Hill (NYSE:TRQ). The site was discovered in 2001, first open pit mining began only in 2013 and underground mining that contains the main resources is expected to begin only in 2021, political and financing conditions permitting.

538 figure 3 years to production

Figure 3: Number of years from discovery to production. Source:

In total the average number of years from discovery to production has gone from an average of 7 years two decades ago to the current average of 20 years as new feasible mining opportunities are mostly found in difficult environments, like Mongolia for example.

The second issue is low mining grades. Due to the fact that the low fruit is usually picked first in the longer term copper is expected to become much scarce. The lower the grade of copper the more ore has to be mined in order to produce the same amount of copper. More mining means higher costs.

538 4 declining grades

Figure 4: Copper mining and reserve grades. Source:

Back to our previous example, the Oyu Tolgoi mine, which is the main copper development project for Rio Tinto (NYSE:RIO), as RIO owns 51% of TRQ, it has a reserve grade of 0.85%. Escondida, the world’s largest copper mine, owned by BHP Billiton (NYSE:BHP) is also experiencing lower grades. BHP anticipates 27% lower grades in 2017.

Lower mining grades and longer lead times should strongly effect copper supply.

Demand for Copper

Copper is used in various industries and the diversification provides a margin of safety in relation to potential disruptions in copper demand.

538 5 figure copper consumption

Figure 5: Copper consumption per sector. Source: London Metal Exchange.

Demand for copper is strongly related to global GDP as population growth and development leads to housing growth and more vehicles and technology being bought. Albeit with ups and downs, the global economy is expected to continue growing and therefore the demand for copper is also expected to grow. When this is combined with the previous supply analysis the following estimation is the result.

538 6 supply deficit

Figure 6: Copper supply deficit. Source:

Lower mining grades and higher demand could create a 10 million ton supply deficit in the long term.

In the short term demand disruption might result from a slowdown in Chinese economic growth as China is responsible for about 40% of global copper consumption. The current slowdown in China is the main cause for copper falling below $2.00 per lb. A continuation in Chinese growth and global development should remove fears around copper.

Another interesting variable is the increase in the number of produced electrical vehicles and a shift towards cleaner energy sources. The production of an electrical car necessities three times more copper than a gasoline powered car. Also, an average of 3.6 tons of copper is used to create a megawatt of wind power capacity.

Copper and the Dollar

Copper prices are expressed in US dollars and therefore copper prices are strongly influenced by US dollar movements.

538 7 dollar copper

Figure 7: Copper vs. the US dollar. Source: Stapleford.

The long term 0.8 negative correlation between copper and the US dollar means that 80% of the changes in copper prices can be explained by changes in the US dollar. Therefore, copper could be also considered as a strong dollar hedge.


The supply deficit should be offset by increased prices that could lead to increased production but at that point the gains from investing in copper should already have been made. Wood Mackenzie estimates that the global supply deficit for copper should amount to 10 million tons by 2028. By looking at the current production cost curve for copper such a supply deficit would trigger an immense boom in prices.

538 8 cost curve

Figure 8: Copper cost curve. Source: SNL Metals & Mining.

With copper demand expected to grow constantly and limited low cost production, the above cost curve indicates that a supply deficit could easily bring to copper prices of $4.00 per pound or higher. Any increase in copper prices above the cash costs is pure profit for the miners and therefore a copper supply deficit could create extraordinary returns.

The best way to invest in copper would be to find a miner that has low debt and low production costs so that it can survive the current slump and a long mine life in order to fully grasp potential future supply deficits. If you are less inclined to investing directly into a miner, a good option is copper ETFs.


A Broader Perspective on the Global Economy

  • Easing monetary policies go on globally but do not seem to fuel sustainable growth.
  • China is slowing, Japan is looking toward another recession, and the global outlook is adjusted downwards.
  • Bad news might be around the corner, but good news is as well.


News is usually focused on the latest happenings. The fact that the human brain is set up in a way that it always tries to focus and eliminate marginal information brings to the consequence that most people do not objectively analyze the world around them. An example: How many blue cars have you seen today? Probably none because you were not looking for them, but as soon as you focus on them you will be surprised by how many you will see. The same applies to finance.

Just two and a half months ago the S&P 500 was 12.5% lower than now and headlines were filled with negative scenarios. Oil prices were below $30 and investors looked to avoid any kind of risk by selling stocks and buying bonds. Then, on February 11, FED Chairwoman Yellen hinted to Congress that “the central bank had increased trepidation over the path of interest-rate increases, pointing to accumulating risks to the economy in recent weeks.” The market focused on prolonged low interest rates and not on the accumulating risks in the economy. This article is going to give a broader perspective on the current state of the global economy in relation to financial markets by taking a look at the situation in the strongest economies.

The US

The main economic indicator, albeit one that shows only what has happened, is the Gross Domestic Product (GDP).

Figure 1: US GDP estimates and actual. Source: The Wall Street Journal – Economic Forecast.

The Wall Street Journal has surveyed 60 economists and their estimations are positive and project stable growth of more than 2%. As shown in the figure above, the previous estimates (red line) are usually stable and positive, while actual results (grey columns) are much more volatile and with negative surprises.

There is a rule in finance where if you are wrong with your estimation alongside others the collective wrongness saves you, but if you are wrong and your opinion is far from consensus, your career is at risk. Unfortunately, this usually brings stable, similar estimates close to each other and big actual surprises.

A more scientific way of estimating GDP is done by the Federal Reserve Bank of Atlanta with GDPNow, as it uses only econometrical models based on economic data variables. Figure 2 shows how this metric diverges from the general consensus above.

Figure 2: Atlanta FED GDPNow forecast. Source: Federal Reserve Bank of Atlanta – GDPNow.

The GDPnow model is forecasting only 0.3% growth for Q1 2016. The first advanced estimate from the Bureau of Economic Analysis (BEA) for the first quarter 2016 is due on the 28th of April and will show who is correct, in any case it could be market moving news.


Japan is still finding it tough to reach stable economic growth. “Abenomics,” the monetary easing policy implemented by Japan’s prime minister Shinzo Abe in 2012, is failing to produce the expected results. If Japan experiences another quarter without growth it will be just another recession that has plagued Japan’s economy in the last two decades.

3 figure 536px

Figure 3: Japan’s GDP growth. Source: Trading Economics.

A recession in Japan should not make a big influence in international markets as it is generally expected that Japan stagnates, but both the incapacity of creating economic growth—even with a negative 0.1% interest rate—and the aging population strongly resembles the situation in Europe.


The Eurostat will publish preliminary flash estimates of quarterly GDP for the EU area on the 29th of April, synchronizing publications with the BEA (usually 15 days later). This is another piece of information that will be interesting for markets.

Estimates from the European Commission are that the EU area will grow by 1.9% in 2016, but the European Central Bank’s (ECB) decisions do not support such a positive forecast. Last week ECB president, Mario Draghi, left the current low interest rate and market purchases policy unchanged and hinted towards further easing in order to bring the EU economy to the expected levels. Almost two years of interest rates close to zero and the ECB purchasing even corporate bonds did not yet push the EU economy towards the hoped levels, an indication that strong growth for the EU might be difficult to reach. Also, Markit’s Composite Flash Purchasing Managers’ Index is showing signs of slowing growth, falling to 13 month lows in March 2016 for the EU.

Other political issues threaten European growth in 2016. The UK will vote on whether to remain in the EU in June and the pre vote polls do not indicate a clear winner. The UK leaving the EU would have significant economic repercussions and increase the political uncertainty that would strongly influence the Euro and the markets. The immigrant crisis from the Middle East is still a concern and possible increases in border controls might further slow economic trade.

Apart from the negative view, there is always hope that the easing policies will work, the weak Euro promotes exports, the UK might vote to stay in the EU, and immigration might help improve the negative demographics in Europe.

China and Emerging Markets

A fact that was soon forgotten is that the Chinese economic growth in the last few quarters was the slowest in the last 25 years.

4 figure 536px

Figure 4: Chinese economic growth from 2010 to 2016. Source: Trading Economics.

China is still growing but many expectations and models that were based on higher growth rates have to be amended. The economic slowdown did induce the huge drop in commodity values in 2015 and that effect will surely reflect itself in local and global economic measures.

China sneezes and emerging markets get a cold. The largest economic downward adjustments are seen in emerging markets, of which Brazil and Russia are the most pronounced. The International Monetary Fund (IMF) expects that the prolonged slump in commodity prices will have a severe impact on emerging markets as they base their economies on exports of primary goods. Africa’s growth is expected to be around 3.7%, thus far from the usual high single digits.


A quick look at what is going on globally does not give much inspiration. The news did not change much since February except that central banks are going to continue with quantitative easing that gave relief to markets. But, the outlook is much bleaker than it was a year ago and the low commodity prices do not contribute to a global increase in economic activity. The IMF predicted in its February outlook that global growth in 2016 would be only 2.5%, which is 35% lower than the average of 3.8% for the last 6 years.

Even if the above data might be a little bit pessimistic, to brighten up the article, China, Africa, the US and Europe are all still growing, albeit at a slower pace so severe economic crises are not expected. But negative news may be just around the corner, so investors should be careful when assessing their risks.


On International Diversification

  • Markets are more correlated in the short term but strongly diverge in the long term.
  • Currency movements further fuel international divergence.
  • Being overweight a certain market or currency means carrying additional risks that could be removed by international diversification.


One issue that is more often off than on investors’ minds is international diversification. Historically, cross-country equity correlations have been far from perfect but they are becoming more correlated in recent times. The higher correlation is not a reason to shun international diversification.

figure 1 correlations

Figure 1: Cross-country correlation of stocks and bonds. Source: Viceira, Wang, Zhou – Harvard Business School.

The main point behind international diversification is that due to the lower correlation between markets it should lower the risks by smoothening the volatility of a portfolio for the same expected return. This happens because the international part of the portfolio is less likely to be affected by domestic market changes. The globalization of trade flows and higher capital markets integration increased the international correlation among markets and consequently lowered the potential benefits. But, as correlation is always measured in the short run, in the longer term it should bring to the expected benefits of reaching the same returns with lower risk because the long term correlation is much lower.

Lower Long Term Correlation of International Markets 

The long term correlation among international markets is lower than the short term due to several reasons. The first one is that even if in the short term the global integration of capital markets makes it look like they are correlated, in the longer term structural influences prevail. The following two figures show the difference between short and long term correlation.

figure 2 1 year correlation

Figure 2: 1-year correlation between the S&P 500, AEX (Dutch index), iBovespa (Brazil) and FTSE (UK). Source: Yahoo.

The difference among the above indexes in one year is only 10% with the AEX being the worst performer. This small difference makes investors forget about international diversification. But in the long term things are completely different.

Figure 3 10 year correlation

Figure 3: 10-year correlation between the S&P 500, AEX (Dutch index), iBovespa (Brazil) and FTSE (UK). Source: Yahoo.

In the longer period of 10 years the differences are much larger. The Brazilian index is the most volatile and the S&P 500, AEX and FTSE move along for a while but strongly diverge in the total period. The above figures show the movement of the relative stock market indices without taking into account currency effects. Currency effects are the second important factor in international diversification. The below figure shows the example of the USD/EUR currency pair.

Figure 4: USD/EUR currency pair from 2006 to 2016. Source:

On top of the previously explained market divergence the dollar strengthened in relation to the EUR from 0.62 EUR per 1 USD in 2008 to the 0.95 EUR per 1 USD. That represents a divergence of more than 50% and shows how the currency effect can influence international correlation in the long term. Currencies are strongly influenced by economic trends and that is the third factor influencing international correlation.

Economic Influences

The below cumulative GDP growth chart shows how countries experience different growth levels in longer periods. The UK and the US have grown 50% faster than the Netherlands while Brazil grew 100% faster than the US in the period from 2000 to 2015.

Figure 5 cummulative GDP growth

Figure 5: Cumulative economic growth for the US, UK, Netherlands and Brazil from 2000 to 2015. Source: World Bank.

Economic divergences are a consequence of longer term structural effects and global cycles. Currently the Euro is considered weak due to the low interest rates in Europe, slow economic growth and no short term positive economic catalysts on the horizon. On the other side, due to the weakness of the currency European products are cheaper internationally and that could influence faster economic growth in the future. In the meantime, the strong dollar makes US products globally more expensive and this could lower the currently stronger economic growth of the US.

The above long term factors also lower the risk of a portfolio in a long term and are important factors to think about when investing. But, even if the benefits of portfolio diversification are clear in the long term, investors stick to their domicile markets. This phenomenon is called the equity home bias puzzle.

Equity Home Bias Puzzle

An interesting feature in the international markets is the home bias. It describes the tendency to invest the largest part of one’s portfolio in domestic securities despite the benefits of international diversification. University of Chicago researchers, Moskowitz and Coval have found that specifically US investment managers exhibit a strong preference for locally headquartered firms that often create asset pricing anomalies. A Morningstar research in 2013 found out that US mutual fund investors keep only 27% of their equity allocation in not US domiciled funds while the Equities not domiciled in the United States accounted for 51% of the global equity market. It is logical that investors prefer the familiar but each investor should assess its own exposure to a certain currency and evaluate his long term risks related to that exposure.

The Strength of the Dollar

Being overweight one market means betting on the success of that currency or market in relation to other markets and currencies. Therefore, such an overweight investor has to assess potential international macroeconomic influences on his portfolio. Such long term economic shifts are very difficult to time and therefore considered betting. US investors have had a great investing performance in the last few years with Europe starting quantitative easing, commodities, that are the main wealth resource of emerging markets faltering and China experiencing a soft landing. But, the below figure that compares the US dollar to a basket of foreign currencies shows how risky an overweight currency strategy can be.

Figure 6 U.S. dollar index

Figure 6: US dollar index from 1967 to 2015. Source: Wikimedia.

An astute investor could also use the above evident shifts and allocate different weights to various markets in relation to their current weakness but that is a different story and requires high macroeconomic knowledge and insight.


The main idea behind this article is to give food for thought. International diversification might not be relevant in the short term but in the longer term it can provide certain benefits. There are various ways of being internationally diversified, through buying different indices or by buying stocks of the same sector that have a different geographic focus. A clear example for that are utilities, they provide relatively stable returns and dividends and when dispersed internationally can lower the volatility of a portfolio.


An Investigation Into the Relative Cheapness of the Automotive Industry

  • With a PE ratio of 5 to 10 the automotive industry looks attractive
  • The risks are that the industry is considered to be at a historical peak by most analysts
  • A global perspective gives a bullish outlook for the industry


The automotive industry is usually called a cyclical industry, considered elastic in relation to GDP and vulnerable to economic shocks. According to a former Ford chief economist a normal recession reduces sales by 15%. With sales being reduced by 15% and costs being inelastic the decline in sales is the one that makes the difference between strong earnings and big losses. Any sign of a recession puts people off from buying new cars and makes them stick to the car they have for a little longer. Connecting the cyclicality and cost inelasticity with the current valuation for automotive companies brings to interesting conclusions.

Automotive Valuation

The current valuation of the 10 biggest automotive corporations is really cheap. In the below table most companies have a PE ratio between 5 and 10. Fiat-Chrysler has PE ratio of 31.8 but adjusted earnings are much better due to a one-off charge of €830 million for the realignment of their US production which brings to a forward PE ratio of 5.1. Tesla is included in order to show how a positive sentiment can easily influence valuations in a completely opposite way than the industry standard.

Screen Shot 2016-04-20 at 4.22.17 PM

Figure 1: Automotive valuation. Source: Morningstar.

A PE ratio in the range of 5 to 10 when compared to the S&P 500 average 24.25 almost suggests that the car industry is about to go belly up. Even oil companies, that have witnessed severe declines in oil prices and revenues have better multiples, Exxon Mobil has a PE ratio of 22.3 and Chevron has 40. Most of the automotive companies trade at prices lower than their book value and price to sales ratios are also much lower than the S&P 500 average of 1.86. In order for the automotive industry to be valued similarly to the S&P 500 their prices should increase at least two fold and for some three fold. The low valuation suggests that there are some short to medium term negative factors expected for the industry.

Potential Issues

One of the potential issues that put off investors from paying higher multiples could be the expectation of higher interest rates. Higher interest rates, not only make it more expensive to pay for the debt the


Figure 2 U.S. gross domestic product in billions of dollars. Source: CBPP.

companies hold but also make buying a car more expensive for customers as up to 85% of new car purchases are financed.

Another issue could be the expectation of a recession. US jobs data is showing the first signs of topping out. Usually the job market peaks prior to recessions when the actual GDP surpasses the potential GDP and there is full employment.

Product recalls and regulatory issues also represent a big risk. Such news usually come as a surprise and have a large effect. The Volkswagen scandal of last September is a perfect example of that. But maybe all those potential bad effects are already priced in seeing the low stock valuations.

The most pessimistic analyst for the auto industry is Max Warburton from Bernstein Research who summarizes the above with the statement that:

“Buying autos this late in the global economic cycle is arguably dangerous–precedents suggest the sector usually delivers most of its performance early in the cycle.”

On the other hand, Warburton is mostly focusing on the US while the source of the bullishness for the automotive industry lies in emerging markets.

A Bullish Outlook

Increased interest rates and recession risks are lower than they were 20 or 30 years ago because the automotive industry has become a global one and is not confined to anymore to Europe and North America.

vehichle sales per region

Figure 3: Global automotive sales forecast by region. Source: Statista.

Sales in North America and Western Europe look stable and constant in the last 20 years but sales in Asia show huge growth. The global sales diversification from 1999 when more than 75% of car sales were made in North America or Western Europe to today’s numbers where about 50% of sales come from China and other Asia show how car companies have become globally diversified and increases in US interest rates or a US recession would have an impact but not as strong as it used to have in the past.
cars gsp

Figure 4: Cars per 1,000 people in relation to GDP. Source: MDPI.

A positive long term catalyst is the still huge growth potential car companies have in Asia, South America and Africa.

In order to reach saturation levels like in Western Europe or North America the Asian market has still to grow more than 10 fold. This would mean global car sales would be at least double the current in a conservative estimation. Of course, the living habits and infrastructural possibilities in Asia are far from the ones in the West but the above chart shows how big is the automotive industry potential.

The Tesla Craze

Tesla is often called the “big disruptor” in the industry with the hope that electric cars will take over the world and Tesla will be the leader. Well, reality is far from that. The recently announced Model 3 deliveries will start only in late 2017 and the profitability of it is highly questionable seeing that the Model 3 is similar to the current Model S and Tesla is currently losing $18,331 per sold car. On the other hand, Chevrolet, part of the GM group, will start delivering Chevrolet Bolt by the end of 2016 with more than 200 miles of range and for a price around $30,000. Other competitors with much more experience and better cost efficiency than Tesla are also entering the electric market. For example, by the end of this year Hyundai should introduce its electric vehicle, Ioniq.


Companies with PE ratios from 5 to 10 with positive future global growth prospects seem a crazy idea. But, historical perceptions of the risks related to the automotive industry keep their valuations low and provide investing opportunities. Regional recessions or interest rate increases should be offset by emerging markets growth in the increasingly global automotive market. The speed at which old car companies adapt to new technologies like electric vehicles and unlike new competitors (Tesla) manage to be profitable show that it is better to stick to the old dogs in this case because they are fast in learning new tricks and manage to keep the old fashion profitability. Due to the above mentioned risks every investor should assess his own tolerance for cyclicality but the current yields are very tempting.


Is Brazil an Investing Opportunity?

  • The political situation is corrupted but the country shows growth potential.
  • From a long term perspective, the market is undervalued and currency effects can bring to gains of 80%.
  • Brazil is still a developing economy with a young population and huge potential.


On Sunday the Brazilian congress voted for the impeachment of president Dilma Rousseff. When the senate, likely in the next few weeks, confirms the vote, the Workers party will temporarily be replaced by a center-right administration government. The move from left to right creates hopes for investors as they look for a more investing friendly environment. Before analyzing investment opportunities, a further note on the political environment is necessary. Of the 513 deputies in the Brazilian congress more than 150 deputies are involved in crimes but are protected by their parliamentarian status and in total 303 deputies face charges or are being investigated for serious crimes, therefore any investment in Brazil has to be discounted for corruption issues that are widespread in Brazil. As the figure below shows Brazil is highly corrupt.

Screen Shot 2016-04-20 at 9.49.04 AM

Figure 1: Corruption perceptions index 2015. Source: Transparency International.

This means that the rule of law is weak and some logical investment decisions or expected results might be completely turned around by corruption issues.

Brazilian Economy

On the other hand, the Brazilian economy is the 7th World economy with a GDP per capita of $15,153, thus with still lots of room to grow in order to reach the developed levels. In addition, it has a young population with 40% of the population being younger than 25 (US – 33%, Germany – 23%). Also Brazil is rich in natural resources ranging from iron ore to agricultural products. All these positive circumstances strongly influenced Brazil’s economic growth in the last 25 years.

Screen Shot 2016-04-20 at 9.49.22 AM

Figure 2: Brazil’s GDP annual growth rate. Source: Trading Economics.

Except for the 2009 crisis and some minor recessions in the past Brazil has seen high levels of growth in the past. The question now is: Is the current recession a temporary and natural halt to the growth cycle or there are deeper structural reasons that will disable Brazil’s future growth? With the current political situation it will for sure take a while before things return to the previous growth levels but for those investors that stick to the “Be greedy when others are fearful and be fearful when others are greedy” Brazil might be the place to look at.

Investment Perspective

All this political turmoil and economic recession resulted in the fact that Brazil is among the cheapest markets by the Cyclically adjusted price earnings ratio (uses 10-year average earnings for PE ratio calculation).

Screen Shot 2016-04-20 at 9.49.59 AM

Figure 3: Brazil’s CAPE ratio. Source: Star Capital.

The average normal PE ratio for Brazil is high at 42 but that is logical due to the current recession and high interest rates. Any improvement in Brazil could quickly bring the CAPE valuation to a more appropriate one for such a young, rich in natural resources and still developing country.

Another potential catalyst is the Brazilian currency. From a stable range of R$1.5 to R$2 Brazilian Reals for one US dollar the Real had depreciated to R$4 for a dollar in 2015 and currently the exchange is R$3.61 for a dollar.

Screen Shot 2016-04-20 at 9.50.24 AM

Figure 4: BRL per 1 USD. Source: XE.

Any indication of a political stabilization and a positive economic outlook would quickly improve the exchange rate and create currency gains for foreign investors. The current base interest rate in Brazil is 14.5% which implies that there will be strong demand for the currency if the investment environment stabilizes. A return to the exchange levels prior to the current economic crisis of R$2 for $1 would create returns of 80% just from currency benefits.

Another positive for Brazilian companies is their surprisingly high level of financial transparency. The financial statements are easily accessible on most of their investor relations web pages and also translated into English.

How to Invest

The easiest way to invest in Brazil for foreigners is through American depositary receipts (ADR) of Brazilian companies traded on the US stock exchanges. Below is the list of the 25 Brazilian ADRs traded on the US stock exchanges.

Screen Shot 2016-04-20 at 9.51.42 AM

Figure 5: Brazilian ADRs. Source: TopForeignStocks.

Another option is to invest thorough Brazilian ETFs. Some of the most popular are the iShares MSCI Brazil Capped ETF (EWZ) that tracks the MSCI Brazil 25/50 Index and the Market Vectors Brazil Small-Cap ETF (BRF) that tracks Brazilian small-caps.

Current Situation

The current market situation shows that the bottom in the Brazilian market was reached in January 2016 with a low of 37,497. Since then it has grown to the current 52,894 or 40% influenced by the expectation that a new government will improve the situation and the 15% appreciation of the Brazilian currency.

Screen Shot 2016-04-20 at 9.52.27 AM

Figure 6: Brazilian stock index BOVESPA 1-year chart. Source: Bloomberg.

The latest 40% surge creates an uneasy feeling of being late to the party but positive economic news and political catalysts could further improve the situation.


Investing in Brazil should be considered high risk because as the market grew 40% in the last few months, so it can quickly decline. On the other hand, the risk/reward is very tempting. Signs of economic strength or a positive outlook would quickly strengthen the currency and bring to immediate gains. Consequently, a lower base interest rate would bring to a much needed relief for Brazilian businesses. The average CAPE of 8.2 further increases the upside potential. South Africa, a country that can be compared to Brazil, has a CAPE ratio of 19.1. A similar CAPE ratio for Brazil would mean a 100% gain on top of the potential currency gain. But, the risks are also very big. A continuation of the current political turmoil does not help a country in economic trouble. New political scandals like the Petrobras scandal where 100 people, including senators and top executives have been arrested, could happen in almost any company in Brazil. An example of how high the corruption goes in Brazil is that the president Dilma Rousseff was a chair at Petrobras when the money laundering activities started back in 2004. Further political instability could further destabilize Brazil, weaken its currency and quickly reverse the above mentioned potential gains. Investor must be aware that although Brazil has a potential for 100% returns, it also has the potential of huge losses.


A Coal Perspective on Commodities

  • Coal has seen lots of bankruptcies but companies continue to produce and the price remains low.
  • Iron ore provides better investing opportunities and a better demand scenario.
  • Low cost and low debt producers with increasing demand should be the best risk/reward investments.


Yesterday’s newsletter mentioned that there might be opportunities in the commodities markets. Today’s letter is going to elaborate on why the coal mining industry is seeing many bankruptcies and extract important insights in order to enable finding opportunities in other commodities that minimize risks and maximize returns.

Coal Mining Industry

If commodities prices go down, as it is the case for coal, slowly but surely, some of the companies engaged in the production of the specific commodity are bound to fail. As the below figure shows, the decline in coal prices is not an extreme case seeing that the price decline from the 2010 high is about 50%.

Screen Shot 2016-04-19 at 12.17.26 PM

Figure 1: Thermal coal price from 2001. Source: InfoMine.

Oil (65%), copper (53%), iron (72%) and natural gas (62%) prices have all declined more than coal prices from their highs but coal miners are the ones having the most difficult times. In January Arch Coal Inc (NYSE:ACI) filed for bankruptcy and last week Peabody Energy Corporation (NYSE:BTU) did the same increasing the already long list with Walter Energy, Alpha Natural and Patriot Coal that filed for bankruptcy last year. If we would add Cloud Peak Energy (NYSE: CLD) to the above list, we would have more than 50% of US coal production bankrupted. The high number of bankruptcies in coal implies that commodities do not always rebound from a downturn cycle as most investors and managers expect and that down cycles can last longer than liquidity available to companies. Other things that are not helping coal miners are environmental pressures and low gas prices that are lowering domestic and international demand. Apart for slowing demand, another factor that influenced the above mentioned bankruptcies was chronic indebtedness. BTU had 69% of assets financed by debt, CLD 67% and ACI 65% back in 2011 when things still looked good for coal miners. With the bad sentiment, debt became more difficult to refinance, impairment charges become imminent and declining margins brought to the above mentioned bankruptcies.

Another crucial factor for miners and other commodities producers is the cash cost in relation to the average selling price.

Screen Shot 2016-04-19 at 12.17.39 PM

Figure 2: Coal production costs. Source: Martson.

As US production is the most expensive, combined with the declining demand, high debt the large number of companies bankrupt or close to bankruptcy should not be a big surprise. But all the data above should give a clear indication of what and where to look for in order to find over performing opportunities in the beaten commodities world.

What to look for?

Now that the things to be careful about are known let us see if there are better commodities markets that allow grasping the opportunities that a downturn commodity cycle brings. The coal case brings to the conclusion that before investing in miners or other commodities producers, investors should look at:

  • The supply/demand structure of the commodity. Declining demand with unrestrained supply leads to ugly scenarios.
  • High debt levels combined with cycle downturns make refinancing very difficult and lead to bankruptcies.
  • The lower the cash cost of producing the commodity the more time the company has to weather a cycle downturn.


Oil might experience a coal like scenario if electric cars become able to weaken the increasing demand for liquid fuels. For now, the general expectation is that oil production will grow at a slower pace than demand seeing the lower oil prices.

Figure 3: World Liquid Fuels Production and Consumption Balance. Source: EIA.

A look at the production cost curve shows where to look for survivors if the slump in oil prices continues.
Screen Shot 2016-04-19 at 12.18.05 PM

Figure 4: Oil production cost curve.

The above figure shows that the lowest cost producers are mostly state owned companies and western world corporations have lower margins. This limits the investing potential and increases the risks as the lowest cost producers are not investable. On the other hand, with the ease of adding production in relation to increases in oil prices it can be estimated that the price of oil and thus also oil stocks will be volatile. Investors should always keep in mind the possible coal scenario due to the potential decline in demand influenced by electric vehicles.

Iron Ore

Iron ore is a commodity that is strongly related to steel production and steel production is strongly related to World GDP growth. As World GDP growth is strongly correlated to demographics most long term analyses show that the global economy will grow at about 3% in the long term as global population is expected to reach 9.5 billion in 2050. This growth should be reflected in demand for steel and consequently demand for iron. The cost production curve is more favorable for investors as the lowest cost producers are corporations and not state owned companies like for oil.

Figure 5: Iron ore cost production curve. Source:

The biggest producers like Rio Tinto (NYSE:RIO), BHP Billiton (NYSE:BHP), Fortescue (ASX:FMG) and Vale (NYSE:VALE) have the lowest production costs and are trying to eradicate the higher cost producers by keeping supply higher than demand.

Figure 6: Supply and demand for iron ore. Source: LKAB.

The supply is just marginally higher than the demand but by looking at the above cost curve (figure 5) any production shut downs from the more expensive producers could quickly erase the current supply glut.

A look at the debt ratios from the above mentioned iron ore producers shows that RIO has 59% of assets financed with debt, FMG 65%, VALE 62% and BHP is the best with only 48%. A deeper investigation before investing is necessary here as most of the above companies are involved in more commodities and not just iron ore.


The combination of low cost production, low debt, demand growth for the product and a compelling price is surely one that is hard to find. But seeing that commodities prices have fallen more than anyone expected there might be opportunities created by market panic. Goldman Sachs, notorious for its bullish oil price forecasts of $200 per barrel for 2009 and $100 for 2015 that ended with oil prices down to $40 in 2009 and $30 in 2015 is a perfect example how experts can be dead wrong. Wrong bearish forecasts by experts should be the ones that create the biggest opportunities for investing in commodities.

One final warning, the interesting thing with coal is that even if the biggest players declared bankruptcy, they did not stop producing. This trashes most managers’ and Saudi Arabia’s thesis that the downturn will end when companies start failing, because even if companies go bankrupt they will continue to produce as long as production costs are lower than the market price.  All a bankruptcy does is shift ownership of the company to the debt holders and continues to depress the commodity price, since these bankrupt companies do not immediately stop producing.  This clearly explains why oil fell from above $100 to $30 per barrel and has had a difficult time recovering.  As long as a company can produce at a cost lower than the market price, it will continue doing so. Therefore certain commodity prices could remain low for an extended period of time, which strengthens the thesis that the low cost and low debt producers are the best risk/reward investments, when acquired at a reasonable price.