Why platinum is cheap

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I was interviewed in Cape Town a few days ago by Chris Mayer, author (or should I say wordsmith) of the Capital & Crisis newsletter. The newsletter only cares about one thing – value. Investment strategies come and go, but history shows that buying value is the only reliable way to build your wealth year after year with the least risk. Read more about Capital & Crisis here.

The interview was broad-based, but emphasized my views on platinum and the South African stock market. (Also see my blogs Be ready for rebound in platinum – BUY!” and “South African stocks – resources offering value again”.)

The paragraphs below come courtesy of Chris Mayer and Capital & Crisis.

While in Cape Town, we had a meeting with Dr. Prieur du Plessis, president of Plexus Asset Management. Du Plessis was a perfect gentleman in all respects, and I enjoyed our meeting with him, in which we ranged over many topics. Below, we’ll take a look at a few of du Plessis’ observations, in particular his argument why platinum is cheap.

Du Plessis, you may have guessed, is a French name. French Huguenots faced persecution in the 17th century and some of them wound up here in South Africa. Of these Huguenots, author H.V. Morton notes in his book In Search of South Africa (1948), “their true memorial is… the great wine industry of the Cape. With the Huguenots came men who knew all the secrets of the French vineyards.”

So it was appropriate that we met du Plessis at one of these celebrated vineyards in the Durbanville Wine Valley, only about 20 minutes from Cape Town. The valley is picturesque, as you can see from this shot of the Nitida Farm, one of the 12 wineries here:

We met at Cassia Restaurant, which I highly recommend should you ever get to this part of the world. Over fresh line fish and excellent wines, we talked about investing in South Africa.

From a big-picture point of view, du Plessis believes the market is fairly valued. He favors looking at the long-term price to earnings ratio of the market as a whole. Specifically, he looks at Robert Shiller’s cyclically adjusted price to earnings ratio, or CAPE. It sounds complex, but very simply, it is a 10-year look at earnings in an attempt to smooth out the fluctuations from year to year. The theory is that if a market gets too far above (or below) its CAPE, you can expect it to revert to the mean over time.

On this measure, South Africa’s market is only slightly above its long-term average of 17, as this next chart shows:

This is a helpful backdrop, but the problem with CAPE, as du Plessis well knows, is that markets can stay over- or undervalued for long stretches of time. As du Plessis points out, using CAPE, you may be out of the market for a long time and miss significant upside.

Nonetheless, du Plessis has his favorites. Resource stocks, for example, have trailed the broader market. So if you compare the price to earnings ratio of only resource stocks against the broader index, you’ll find that resource stocks drift near multiyear lows:

Source: I-Net Bridge; Plexus Asset Management.

“Some stocks, such as Anglo American, are currently trading at earnings multiples last seen during the 2008/2009 liquidity crisis,” du Plessis says.

Another resource idea du Plessis liked is platinum. Platinum sold off heavily after the Tohoku earthquake that struck Japan in March and wrought so much destruction there. Why did platinum sell off? Du Plessis filled us in.

The biggest use of platinum is in automobiles. Post-quake, the Japanese auto industry produced about 535,000 fewer cars in the month of March compared to the year before — a drop of 57%. This is a trend that continued into April. Du Plessis estimates that from March to May, the total loss in vehicle production will be about a million vehicles.

Doing the math, Du Plessis figures the total lost demand for platinum could exceed 100,000 ounces. “While it seems small,” du Plessis continued, “the 100,000 ounces should be compared to the average investment demand of approximately 55,000 ounces (2008-2010). That is huge!”

Platinum, like gold and silver, enjoys a certain demand solely as a means of storing wealth. It is one of the precious metals. To see platinum’s price weakness most clearly since the Tohoku quake, du Plessis plotted it against the price of gold. As you see, by this measure, platinum is quite cheap relative to gold:

Sources: I-Net Bridge; Plexus Asset Management.

“I think it is only a question of time before platinum’s premium to gold will be restored,” du Plessis offered. He then presented an eye-opener of a chart comparing the price drop in platinum that happened after the Kobe earthquake in 1995 with the one after Tohoku. Take a look at this:

Sources: I-Net Bridge; Plexus Asset Management.

Will history repeat? Who knows for sure, but it seems platinum is a good bet.

This is also something I heard more than once meeting with miners in South Africa. I asked an executive director at African Rainbow Metals — which produces all kinds of commodities — what the cheapest commodity is. Without hesitation, he said platinum.

There is another reason to like platinum. South Africa has most of the supply, as this chart shows (As one geologist put it, the supply of platinum remains in the hands of “geological freaks of nature”):

And South Africa is having problems making more. First, the strong rand, South Africa’s currency, is eating into South African profit margins. Second, South African producers are suffering from rising electricity and labor costs. So, importantly, the price of platinum must rise in rand terms — or else we won’t see new supply from South Africa.

New supply is hard to bring online too. The Financial Times recently quoted an RBC analyst: “Even if the price hit $2,000, where would the normal supply-side response come from? In South Africa, there is no extra electricity to expand your production into. All the big producers want to expand, because they see the demand growth coming, but it’s an uphill battle with the power problems and labor problems.” And, I would add, the strong rand.

Therefore, buy platinum.

There are many ways to play it, including through platinum mining stocks. I’ll be giving some of these a look soon.

After the meeting, as we headed back to Cape Town, heads swimming in good wine and bright sunshine overhead, we had a lot to think about. For sure, we left with a very good opinion of Dr. du Plessis, as gracious a host as one could hope for and a sharp-eyed observer of financial markets. You can find more from Prieur du Plessis at his excellent blog Investment Postcards from Cape Town, at http://www.investmentpostcards.com.

Source: Chris Mayer, Capital & Crisis, May 27, 2011.

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