The sky might be falling in but what goes down, must come up.
I joined Warburg Dillon Read’s equity research department in Summer 2000. The dot com boom was in full flush and I was working in an Old Economy sector. We really weren’t flavour of the month. Then two things happened in quick succession: UBS bought Paine Webber at the top of the market and the dot come boom bust.
That was my first recession in investment banking and it was a doozy. Luckily, as a junior analyst I wasn’t required to help with the predictions. I was just there to learn. And learn I did, from some of the best minds in the industry at that time.
What I learnt is that, however bad things look, there’s always a recovery. And people can make a lot of money in a recovery. Some of them are lucky enough to replace all they lost. Some of them are lucky enough to make more.
Another thing I learnt is that in a recovery from a recession there can be several false dawns. In 2001, the Dow Jones Industrial Average hit a V-shaped bottom in September 2001 and then a U-shaped bottom between July 2002 and March 2003. In the GFC, there was a succession of lower lows and then one horrific collapse until March 2009 when the effects of Chinese stimulus resulted in a V-shaped recovery.
But I also learnt that recoveries are normally rapid, much more rapid than you would think.
In 2001, the initial move down was 27% on the Dow Jones, which then bounced up +21% in the following three months. In March 2009, the index bounced +40% off the lows in only four months. Generally, share prices don’t stay down for long once a trough has been reached.
And this is something that analysts at investment banks are always bad at forecasting. Some might say that investment banking analysts are bad at forecasting full stop. I’ve worked on both sides of the fence and I kind of understand both points of view. Generally, investment banking analysts are behind the curve. There’s a reason for that and it’s because an analyst often has a larger infrastructure behind them that may be unseen to an outsider.
To give an example, at GMP Europe in the GFC, I was able to go positive on the Mining sector straight after the Chinese stimulus. Because it was only my call. At Haitong in January 2016, my Underweight to Overweight call on the sector was rewritten into a Neutral call by colleagues who were unhappy to take a view on Chinese housing recovery.
That’s what an analyst at an investment bank often has to deal with, whereas a Fund analyst or Portfolio Manager, or even an individual investor, can simply make a move as soon as they see something changing.
Anyway, that is by the by. What battery materials sub-sectors and stocks should an investor expect to hold into a recovery?
Well, there is a delightfully pithy phrase, that I shan’t repeat in these hallowed pages, which highlights what kind of stocks you want to invest in for a recovery. And basically it comes down to the fact that into a recovery you want to buy the stock with the most operational and financial leverage.
That means the stock with the highest cost operations, the most debt or both. In short, the stock that was the closest to going bust in the downturn! In 2002-03 in the mining sector that was Phelps Dodge (whose assets are now part of Freeport-McMoran) and in 2009 it was Hudbay Mining and Fortescue Mining.
A lot of investors make a mistake and go for the highest quality company. They invest in quality like BHP (ASX:BHP) or Rio Tinto (ASX/LSE:RIO). While that’s a reasonable trade in the downmarket, it’s less good in a recovery. Why? It’s about earnings growth.
Take two lithium producers, LowCost and HighCost, in a recovery where lithium prices go from US$10,000/t to US$14,000/t. LowCost has operating costs of US$6,000/t and HighCost has operating costs of US$9,500/t. LowCost’s profit goes from US$4,000/t to US$8,000/t; a 100% increase. Looks pretty good hey? But now look at HighCost. Its profit rises from US$500/t to US$4500/t; an 800% increase. A bit better, wouldn’t you say?!!
Despite the fact that HighCost has a smaller profit overall, its increase in profit is much more significant than LowCost. And since the market tends to look at P/E and EV/EBITDA multiples to value stocks, then an increase in profit should be directly correlated with share price appreciation.
Financial leverage is similar, except it’s not about the issue of costs on profitability, it’s about the impact of coupon and principal payments on profitability. At various points in past corrections, I’ve bought Corus (the UK steel producer) or Xstrata (the diversified miner finally bought by Glencore in 2014) to take advantage of high financial gearing into a recovery.
So, when you’re making a decision about which stocks to buy in a recovery looking at their operating costs (preferably on an All-In-Sustaining-Cost (AISC) basis) compared to the current commodity or material price, and look at the impact of interest and principal payments on their cash flow. The stocks will the lowest adjusted cash flow per share are the ones that you want to buy for a recovery. Good luck!