“Resources versus Financials and Industrials – where are we now?”
By Neels van Schaik
Our regular readers will recall that we have previously discussed the correlation between the relative price performance of a company or index and the relative earnings performance of that same company or index. Recent market movements warrant a re-visiting of the topic.
The red line in the attached graph shows the earnings growth of the Resource Sector (RESI) relative to the earnings growth of the Financial and Industrial Index (FINDI), going back to 1960. The blue line shows the price performance of the Resource sector relative to the price performance of the Financial and Industrial Index over the same period.
A rising red or blue line therefore means that the RESI is growing its earnings and/or price faster than that of the FINDI, while a falling red or blue line means that the RESI is growing its earnings and/or price slower than the FINDI. Over time we can see a very close relationship between a sector’s ability to outperform on earnings and its ability to outperform on price.
What is also evident from the graph is the divergence between the price and earnings performance of RESI relative to the FINDI between January and June of this year. This is the biggest divergence we have seen since the mid-seventies, just after the first oil crisis. Although RESI earnings are still likely to outperform in the next 12 to 18 months, this divergence indicated an overly bullish view of the market on their expectation of profit growth for the Resource sector, a view which we were very skeptical of at the time. Investors made increasing use of ruling spot commodity prices to justify valuation levels in Resources.
This divergence between RESI and FINDI companies has closed almost entirely since June refer the significant drop in the blue line over the period. This indicates that investors have become more uncertain about the outlook for commodity prices and resource earnings growth.
Although the earnings outlook for Resource companies still looks good in the short term, the earnings base is extremely high and volume growth in the next few years remains essential to control unit costs in an environment of slowing commodity price appreciation. In the short term, Resources may therefore regain their sparkle relative to the rest of the market given their short term earnings momentum, but generally the playing fields for earnings growth for Resources and FINDI shares are being leveled. The high profit margins and high real earnings base within Resources is starting to look very unattractive against certain Industrial companies that have already seen erosion in real earnings and will be able to grow off a lower base in the next few years. Resources are therefore unlikely to repeat the outperformance of the first half of 2008, especially now that the sustainability of Emerging Market growth levels is being questioned.
2008 will go down in history as a year of extremes. Bull markets never last forever and consolidation phases are required to build a base for the following upswing. We would caution investors not to act irrationally on extreme newsflow in the current environment. Finding attractively priced companies that deliver relatively safe and predictable earnings and cash flow, even in times of uncertainty should be the main focus of any investor. The dividends and price appreciation will eventually follow.
Source: Neels van Schaik, Alphen Asset Management, September 15, 2008.
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