It is perilously easy for investors to get caught up in the sentiment of the day and buy into 'story stocks'. Not wanting to miss out on the next big thing, the market often drives up the price of favourably positioned assets far beyond their underlying intrinsic value and pushes the perceived losers far below theirs.
This 'headline investing' approach to deciding where to put your money is risky and could lead to permanent capital loss. At these times, there is often considerable emotion involved, and the disconnect between price and value can be extreme. Investing where sentiment is extremely positive, and prices are already high, can be dangerous and often carries the risk of a permanent loss of capital.
However, when the market gets overly negative on a story, an opportunity is often provided for investors who can cut through the almost deafening noise and take the long-term view.
The interaction between supply and demand is the most important variable for pricing and earnings and continued underinvestment in supply has created good value in perceived 'sunset' sectors.
The following three commodity markets serve as useful case studies:
Uncoated fine paper
For at least a decade, paper has been written off as an attractive investment, with most observers expecting a relentless and brutal decline in demand. Despite this bleak outlook, paper producer Mondi has grown earnings before interest and taxes from its uncoated fine paper division almost three-fold since 2007. This surprising outcome is due to a combination of constrained supply, a consequence of underinvestment, and demand proving to be more resilient than most expected. Mondi's low-cost assets and excellent management team have thrived through more than a decade of declining demand. The clear learning in this case is the danger of obsessing over one variable without giving due focus to the interaction between supply and demand, which is fundamental to the price discovery process in any market.
This is another commodity market in which most observers agreed that demand would decline as renewable energy took market share. As a consequence, many investors wrote off coal assets as an investment. What this negative thematic view once again failed to consider is the intersection between supply and demand. Although thermal coal demand will decline over time, it is likely to remain more resilient than many expect. In addition, underinvestment in supply has, and will likely continue to, lead to constrained supply. This has resulted in supply deficits and price increases (over 140% from trough to peak). We expect constrained supply to endure and would therefore not be surprised to see prices remain elevated above incentive prices in the years to come.
Electric vehicle commodities
When the Volkswagen emissions scandal, or 'Dieselgate', broke in September 2015, headlines announcing the death of the internal combustion engine were everywhere. This coincided with the rise of Tesla as an automaker and battery electric vehicles (BEVs) as an alternative drivetrain.
The price of BEV components lithium and cobalt rose quickly in response, while the platinum group metals (PGM) basket price was trading well below marginal cost. Fast-forward 12 months and the rand PGM basket is up 43% - close to lifetime highs - while lithium and cobalt prices are down 56% and 68%, respectively. While we are believers in BEV technology in the long term, the hurdles to mass adoption are significant and they will likely take decades to overcome.
After detailed work on the future of the drive train and ridesharing, we believe that demand for PGMs will be more resilient than most expect. We are of the view that mass adoption will take decades and that hybrid vehicles with similar, and in some cases higher, PGM content than standard cars will bridge the gap between today's cars and BEVs.
In the medium term, we also expect PGM demand to surprise positively as a consequence of tightening emissions standards globally. In addition to this, material underinvestment in mine supply over the last decade means it will take many years before supply can meet current demand. We therefore expect structural PGM market deficits to persist for at least the next decade.
So, what's the lesson here? Scrutinising what is in the price is a critical consideration for making any investment decision.
It's prudent to remember: When headlines scream 'buy' or 'sell', almost regardless of price, only detailed analysis can give one the kind of conviction needed to take an alternative view and go against the tide.
Coronation will be presenting at the Allan Gray Investment Summit in Johannesburg and Cape Town in July 2019. www.investmentsummit.co.za
Book your seat at the Allan Gray Investment Summit taking place on 22 July at the Cape Town International Convention Centre and 23 July at the Sandton Convention Centre.
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