uncorrelated returns: hedge funds as the new gold

Every stock market person knows what beta is.

It comes from a regression analysis, y = α + βx, where y is the return on a stock and x the return on the market).  It shows how a given stock’s past tendency to rise and fall is linked to fluctuations in the market in general.  A stock with a beta of 1.4, for example, has tended to rise and fall in the some direction as the market, but move 40% more in either direction; a stock with a beta of 0.8 has tended to exhibit only 80% of the market’s ups and downs.

The professor in a financial theory course I took in business school asked one day what it meant that gold stocks had, at the time, a beta of zero.

The thoughtless answer is that it means they aren’t risky, or that they don’t go up and down.

A consequence of this thinking is that you can lower the beta, and therefore the risk, of your investment portfolio by mixing in some gold stocks.What’s interesting is that in the early days of beta analysis that’s what some institutional portfolio managers actually did with their clients’ money.

That didn’t work out well at all.

What should have been obvious, but wasn’t, is that the zero beta didn’t mean no risk–or that gold stocks are/were a good investment.  It meant what the regression literally indicates–that none of the movement in gold stocks could be explained by movements in the stock market in general.

The riskiness of gold stocks is there, but it came/comes in other dimensions, like:  how mines develop new supply, the ruminations of the gnomes of Zürich (in today’s world, Mumbai and Shanghai), the potential for emerging country craziness, the propensity of the industry to fraud.

Why write about this now?

I heard a Bloomberg report that institutional investors as a whole are upping their exposure to hedge funds, despite the wretched performance of the asset class.  Their rationale?   …uncorrelated returns.

It sounds sooo familiar.

Admittedly, there may be a deeper game in progress.  It’s impossible to say your plan is fully funded by projecting a gazillion percent return on stocks or bonds.  But who’s to say that a hedge fund can’t do that?



natural resources and economic growth

I ended up with my first stock market job, more or less by accident–and without any finance experience or training–in the late summer of 1978.  A few months later, the firm’s oil analyst was headhunted away and I took his place.  Within a couple of years (an MBA from NYU at night along the way) I had picked up a bunch of metals mining companies, too, and was in charge of the firm’s natural resources research.

The oil industry was (and still is) really non-intuitive–more about my early adventures tomorrow.  Today I want to write about the mining industry, which is a little more straightforward.

natural resources in the 1970s

I started out by reading the annual reports and 10-Ks of the major base metals mining companies for the prior five or six years.  What stood out clearly was that all the firms held very strongly a series of common beliefs, namely:

1.  that global economic growth would continue to be strong for as far into the future as one could imagine,

2.  that the availability of all sorts of base metals–lead for batteries, copper for wiring and tubing, iron ore for steel, and so on–was a necessary condition for this growth

3.  that, therefore, demand for base metals would grow at least in lockstep with GDP increases.

Implicitly, the companies also assumed that:

4. that oversupply was highly unlikely,

5.  that substitution among raw materials–like aluminum or PVC for copper–wouldn’t be an issue, and

6. that, because of 4. and 5., the selling price of output from future orebody discovery/development would never be a concern.

CEOs’ conviction was buttressed by reams of computer paper containing economists’ regression analyses “proving” that all this stuff was true.

a massive investment cycle…

Naturally, the companies, not risk-shy by nature, went all in across the board on new base metals mine development.

As I was reading these documents in 1979-80, the first (of many) massive new low-cost orebodies were coming into production.  This wave turned out to have been enough to keep most base metals in oversupply–and a lot of mines unprofitable–for the following twenty-five years!!!  Miners were also in the midst of a massive switch to exploring for gold, where high value deposits could be developed quickly and at low-cost–causing, in turn, a twenty year glut of the yellow metal.

…that didn’t work out

The mining CEOs turned out to be wrong in a number of ways:

–like any capital-intensive commodity business where the minimum plant size is huge, industry profits for base metals are determined by long cycles of under-capacity followed by massive investment in new mines that causes long periods of over-capacity

–although it wasn’t apparent in the 1970s, substitution of cheaper materials has been a chronic problem for base metals.  Take copper.  There’s aluminum for heat dissipation and wiring, PVC for plumbing, and glass/airwaves for audiovisual transmission.

–Peter Drucker was writing about knowledge workers as early as 1959.  Nevertheless, the mining companies and their economists weren’t able to imagine a world where GDP growth might not require immense amounts of extra physical materials.

I’ve been looking for a sound byte-y way to put this all into perspective.  The best I can do is a gross oversimplification:

–real GDP in the US has expanded by 245% since 1980.  Oil usage is up by about 10% over that period; steel usage is down slightly.  The supposed dependence of GDP growth on increased use of natural resouces simply isn’t true.

Why am I writing about this today?

…it’s because I continue to read and hear financial “experts” say that weak oil and metals prices imply declining world economic activity.  To me this argument makes no sense.




natural resource production companies: accounting quirks to watch for


Mining is mostly about how a company develops resources that have already been discovered, sometimes very long ago.

1.  Metals orebodies can vary considerably from one part ot the next in the proportion of valuable minerals they hold.  Standard practice is to mine the highest-grade ore when prices are low, and the lowest-grade when prices are high.

Not a lot of operating leverage this way.  But the idea is to enable the mine to stay open even during the inevitable cyclical downturns.  Doing the opposite, which will likely boost the stock price in good times, can lead to disaster during the bad.  There’s no easy way for an outsider to tell, except by the reputation of company management.  In the case of gold, we may find out who’s been prudent and who’s been reckless when the 2013 financials are published.

2.  Same thing with site preparation.  Standard, and prudent, practice is to routinely spend money on things like removing overburden (layers of dirt covering the ore) in places where the company is not mining today, but plans to in the near future.  This activity can be quite expensive.  But it’s necessary.  On the other hand, a firm can make short-term profits look considerably better by not doing so.

oil and gas

Oil and gas is much more involved with finding new deposits, and how to account for those costs, than metals mining.

1.  Companies have two ways to account for the costs of buying mineral rights and doing exploratory drilling.  They are:

–successful efforts, where, as the name suggests, only successful fields are put on the balance sheet and gradually written of as oil and gas is produced.  The costs of unproductive areas are written off as expense as soon as they’re incurred.

–full cost, where all exploration costs, both for productive and non-productive projects, are capitalized and written off against production.

Successful efforts is more conservative, but normally results in lower earnings.

2.  Accumulated costs are written off pro rata as each unit of oil or gas is produced.  The amount expensed against the revenue from each unit is its proportionate share of the total cost of finding and developing all oil and gas (it’s a little more complicated than this, but this is basically what you need to know).  That proportion, in turn, is calculated based on periodic estimates by petroleum geologists’ of the total size of reserves.

Big oil companies use their own geologists; smaller ones hire outside consultants.  The important point is that this estimate–and therefore the amount of cost written off per unit produced–can vary a lot, depending on the particular consultant hired.  It may also depend on the tone, conservative or aggressive, company management sets.

Just as important, as I mentioned yesterday, oil and gas price changes can alter the size of total reserves.  The cost of recovery doesn’t change, but the amounts of hydrocarbons that can be brought to the surface at a profit can be.  Lower selling prices can raise the per unit amount expensed;  higher selling prices can lower the unit amount.  Potentially, lots of operating leverage–that’s completely out of management’s control.

3.  A minor clarification of #2:  subject to some limits, the company decides how to group reserves and associated costs into different “cost pools” for figuring out depreciation and depletion.  Artful grouping of these pools can help disguise an extended run of bad drilling luck.  Not usually a worry, except with small firms with limited history.

4.  As with any other capital construction project, when oil and gas companies explore and develop with borrowed money, they can capitalize (that is, put on the balance sheet rather than expense immediately) the interest expense on that borrowing.  The interest expanse becomes part of the general costs that are written off against oil and gas production.  For smaller companies with an ambitious drilling program, this can sometimes create the peculiar (and potentially disastrous) result that it shows positive earnings while it is suffering cash outflows.  This is because interest is being paid to creditors but these payments basically don’t show up on the income statement.  Check the cash flow statement!!




natural resource production companies: proved reserves

Early in my career I interviewed for a job with a company that had brought in a new chief investment officer to revamp its research department–a job I (luckily, as it turns out) didn’t get.  In the interview, the CIO said he thought that any competent analyst could figure out most industrial or service companies, but that there were three areas that demanded special expertise, They were:  financials, technology and natural resources.

Personally, I’d take technology off the list, leaving financials and natural  resource companies as the real specialist endeavors.  I’ve coped with financials by either avoiding them entirely, buying plain vanilla commercial banks in emerging markets, or by mirroring the index (so they neither help nor hurt performance).  As it turns out, I spent about eight years concentrating on natural resource companies at the start of my career (true, during the last century).  Rightly or wrongly, I feel comfortable with them.

Two thing make natural resource production companies unusual:

–their revenues depend on the price of the mineral commodities they mine, which can be very volatile, and

–their stock market value most often depends on the amount and value of their proved reserves, something that only appears tangentially in the firms’ financial statements.  Companies routinely disclose at least some information about their reserves, but it’s in supplemental disclosure that you have to find elsewhere in the annual.

proved reserves

Proved reserves are deposits of minerals that can be recovered:

–at a profit,

–with today’s technology, and

–at currently prevailing prices.

Almost always, natural resource companies have more stuff in the ground than they report as proved reserves.  Two possible reasons:  the minerals genuinely aren’t recoverable at a profit, given today’s technology and pricing; or (commonly with small companies) the firm hasn’t wanted to spend the money to get hard geological evidence of the extent of their holdings.

why this is important

1.  When prices go up, two good things typically happen to natural resource companies:  the value of each unit of reserves rises and the volume of reserves rises as well.  The opposite happens when prices fall.

Most people don’t realize the volume part.  That will be particularly important this year when gold mining companies report their reserves.

2.  When technology changes–as is currently the case with the development of horizontal drilling and hydraulic fracturing in  shale–acreage that previously seemed worthless may suddenly become a big source of profits.

In the case of natural gas in the US, this is a two-edged sword.  The amount of new gas production that fracking has spawned is so great that it has lowered the domestic gas selling price.  This means that some high-cost operations that were previously economically viable are no longer so–thereby moving those reserves out of the proved category for the companies affected.  For particularly maladroit drillers, where the value of the reserves found is barely higher than their finding costs (i.e., where the stock market appeal is purely the bet that prices will rise steadily), fracking can be a death knell.

More tomorrow.



gold mining stocks?

gold mining stocks

I spent part of the day yesterday looking at gold mining stocks.

the potential attraction?  …over two years of dreadful performance.

Since mid-2011, the gold price is down by about a third.  Over the same time span, many gold stocks have lost between half and three-quarters of their value.  And that’s during a period when the S&P is up by about 50%.

Sentiment about gold has also taken a decidedly negative turn.  Hedge fund managers are no longer bloviating (how about that word?) about the superiority of the yellow metal over “fiat money.”  Boiler rooms are no longer filling the airwaves their odd sales pitch that “Gold has tripled over the past five years.  (Therefore you should) buy some now!!”

In addition, I think that 2014 will be a year of consolidation for the S&P.  So a 3% dividend yield plus the chance of, say, a 15% gain looks to me to be substantially more attractive than it might have been a year or two ago.

my verdict

I’m not so interested, for two reasons:

1.  I think the gold price is still too high.  In the past, the gold price hasn’t bottomed until it reaches a level where at least some existing mines become uneconomical.  This means that the cash a company must spend (not including non-cash costs like depreciation) to produce an ounce of gold is greater than the selling price.  As best I can tell (a long time ago, I would have considered myself an expert, but I’m certainly not one now), that’s below $1,000 an ounce.  The price may never get there, but, as an investor, I’m looking for situations with more upside than downside.  I don’t see that here.

2.  I don’t think companies have completely stabilized themselves yet.  The industry took on a lot of debt to fund what have turned out to be ill-advised capacity expansions at the top of the market.  That’s par for the course.

As far as I can see, these projects have by and large been at least temporarily mothballed.  However, there’s still the debt to deal with.  It isn’t so much that there are borrowings on the balance sheet that bothers me.  It’s that financially leveraged firms have to continue to mine in order to repay their lenders.  So supply isn’t taken off the market as quickly as it might otherwise be.  A number of companies had stock offerings last year.  Good for them, but this just prolongs the adjustment period.

All in all, I don’t find the risk/reward to be favorable enough right now.  Maybe in six months.