I started my career as a securities analyst as a generalist. I covered companies in the oil and gas, utilities, and electronics industries as I learned the trade. After I’d been working for a few months, our oil analyst was headhunted away and–poof!–I was the new oil analyst. That reoriented my progress for several years much more toward natural resource companies.
One of the more peculiar ones I encountered as I expanded my coverage was Moore McCormack. A conglomerate, Moore McCormack was originally a shipping firm but had expanded into iron ore and coal mining, cement, and oil and gas drilling.
On the theory that most things happen for a reason–no matter how hard it may be to see the rationale from the outside–I asked the CFO how the company had evolved in such a singular way (I was thinking “into such a ragbag of sub-scale commodities businesses” but phrased my question differently). He told me that Moore McCormack deliberately specialized in holding long-lived assets that required large amounts of up-front capital investment and where the firm was essentially a price taker. In other words, it specialized in commodity mining and shipping.
Why do this? …because, he said (incorrectly, as it turned out), the key to success in these business lines was how the capital investment is financed. And Moore McCormack was an expert in financing.
The company dissolved during the Second Oil Crisis of 1978 and the ensuing recession. It couldn’t survive the sharp shrinkage of cash flow in all of its business lines caused by the ending of an almost decade-long commodities boom and the economic downturn that accompanied/intensified it.
How did this happen?
The base metals industry–shipping, too–is extremely cyclical. But each cycle lasts a decade or so, much longer than an ordinary business cycle. A boom begins when garden-variety economic growth expands to the point where demand for metals exceeds available supply. Fabricators need more copper for construction or iron ore for steel car bodies than existing mines can handle. Or, say, the developed world is using more petroleum than the existing fleet of tankers can carry.
Because it may take five years to open a new mine, or a similar span of time to get a new cargo ship from the yards (a year+ to build, a four-year waiting list), the only way a user can get the commodity inputs he needs is to bid them away from everyone else. So prices go through the roof.
But commodity producers in general, and base metals firms and shippers in particular, are like lemmings. Everyone is making money hand over fist; everyone plows the cash into expanding capacity like there’s no tomorrow. No one puts much cash away for a rainy day; no one diversifies sensibly.
Then–several years, maybe half a decade, into the boom–the first new capacity begins to enter the market. Prices begin to flatten. Then a cascade of new output comes online–much more than anyone can possibly use. Commodity producers frantically put as much of their expansion on hold as they can. But it’s too late. Prices sag. Cash flow shrinks drastically. And the industry waits for world demand to grow big enough to create demand for all the new capacity there is. The bust lasts maybe another five years. And then the cycle begins again.
For base metals, we’re in the decline phase now. I don’t have any idea how long the current period of weakness will last. But I don’t think the turnaround is any time soon.
To me, the interesting question is why managements of companies in long-cycle industries exhibit the same imprudent behavior cycle after cycle. Don’t they know their own industries? Don’t they remember what happened last time around? If they do, they somehow convince themselves that this time will be different.
More on this tomorrow.
A side note: Moore McCormack thought it was diversified, even though it recognized that all its divisions had the same economic characteristics. Sort of like thinking a balanced meal consists of several different flavors of ice cream.
I think you are right about this, i.e., that we are in the decline phase of long-cycle commodities markets. Ten years ago, it was hard to get anyone to consider commodity oriented investments. By 2006, the market was heating-up and now most everyone considers himself a commodities expert. Just as executives in commodities businesses never seem to learn, e.g., “this time is different,” note that most securities valuations are quite high now (bonds are as expensive as they have ever been, stocks are quite richly valued based on trailing earnings, trailing average earnings and Tobin’s Q). Perhaps we (investors) are like those managers of long-cycle industries thinking that this time will be different? Or, perhaps we are struggling to find places to store value in markets that are being inflated by aggressive macro policies.