The Impenetrable Moat of Cyclical Commodity Businesses

  • Commodity producers are difficult to love. Profitability varies widely, driven by even marginal changes in the underlying price of the product
  • Lack of predictability makes it unattractive to most value investors
  • Growth investors are equally cautious, as the high capital intensity of the industry makes growth expensive
  • Quality investors distrust the management of commodity operators, who perceive them as reckless capital allocators
  • Despite the cyclicality inherent in the industry, the lowest cost operators can offer both above-average returns and a lower risk of permanent loss of capital

Only a subset of commodity businesses has a moat, but when they do they are difficult to beat. Low cost commodity businesses benefit from advantageous geology that can’t be replicated elsewhere and is not subject to changes in consumer taste and won’t easily be disrupted by technology. If one is able to withstand short term stock volatility and is able to buy at a discount to normalized earnings power, we believe these businesses offer long term returns that are superior to the overall market.

Resilience Behind The Moat

  • Structural competitive advantage is often defined as a moat
  • Moat can come from a variety of factors including a strong brand name, economies of scale or customer switching costs. Structural competitive advantages are difficult to maintain and erode over time
  • Commodity operators may not benefit from high entry barriers but their main potential advantage, a low cost production base, is highly durable
  • Low cost position is often derived from an advantageous geological position that is very difficult or impossible to replicate
  • A low cost position does not stop the industry from being cyclical but it does give these firms staying power in times of a cyclical downturn

Low Cost = Less Pain

  • Commodity business experiences the ultimate boom and bust capital cycles
  • Periods of high prices attract entry from marginal producers with structurally higher costs
  • Although construction takes time, once the new supply enters the market, prices decline, as demand often has not caught up to the growth in supply
  • Sharp decreases in commodity prices reduce industry-wide profitability but the pain is not distributed equally
  • Highest cost operators become cash negative, while low cost operators often maintain healthy margins (i.e. from 2014 to 2015, price of iron ore dropped from $130 to below $40/tonne while Rio Tinto maintained operating margins of 25% in its iron ore division, paid down debt and paid out dividends; this occurred while many new entrants and high cost competitors were forced to shut down their mines)
  • Reductions in production do not happen overnight and fears of structural low prices drive down share prices for the whole industry. This happens even to the lowest cost operators, which creates the opportunity to purchase them at low multiples of depressed earnings, never mind their normalized earnings power

Embrace the Decline

  • When commodity prices are low, investors fear further declines and shy away from buying low cost operators. Further declines should not be feared, they should be embraced
  • Accelerated price declines speed up the restructuring process and often cause a faster and more rigorous exit from high cost competitors
  • Low cost operators are able to withstand these downturns better than anyone else, as they tend to have the best balance sheets in the sector. Their higher returns reduce the need for external financing and reduces the risk of a permanent loss of capital
  • Depressed environment has the added benefit of making management more cautious of large scale investments as well as acquisitions. This improved, although temporary, capital discipline reduces the risk of poor capital allocation decisions

Kempen & Co: The Dividend Letter, October 24, 2017

Image Source: Bernstein


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