05/03/2008 - 22:00

Resources rides to the rescue, again

05/03/2008 - 22:00

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Commodities appear to be replacing property as a haven for short-term investor savings as stock markets work their way through a bear phase.

Resources rides to the rescue, again

Commodities appear to be replacing property as a haven for short-term investor savings as stock markets work their way through a bear phase.

Although there are always points of commonality in each economic cycle, every boom and bust has its own twists and turns and each one unfolds in a different manner. As outlined in previous columns, Briefcase believes that, this time around, property will not provide a traditional safe-haven role, but the current focus on raw materials could be a boon for the Australian economy in the long term.

Residential property from Spain to England and the US is presently in a downward tail spin. Overall, property prices in the US have fallen by an average of about 10 per cent from their peak and look like falling at least another 10 per cent this year. Regionally, in the worst hit hot spots of the US’s property meltdown, property prices have fallen by more than 15 per cent, despite plummeting interest rates. Over-building to the speculators baton in the south of Spain has caused huge pain, especially to UK investors. That pain is now reflected in property markets in the UK’s southern counties and has spread to other pockets around the UK.

With cash rates in the US hovering around 3.5 per cent a year, investors in that market are looking further afield for fertile investment paddocks. Hence, it is not so surprising to see that commodities, such as coal, copper, cotton, cobalt and corn, along with gold, platinum, oil, iron ore and wheat are all rising strongly under the influence of physical shortages and growing demand – all mixed up with speculators and investors looking for a place to work their funds.

Last week’s rebound in the market was almost entirely due to strength of the major resource companies, which are caught up in the commodity price boom.

So far, despite an almost doubling of the gold price over the past three years, Australia’s gold mining and exploration companies have shown little market form. Briefcase believes the market needs a spark from a significant new discovery to light a fire under the gold market. Selecting the next company to make a big find is the hard task, but companies with funding or cash flow to support a drilling campaign, plus management who know how it is done, would be high on the list.

•••

During the past year or so, Briefcase has marvelled at the lack of inflation in Australia, given rising energy and raw material prices. This trick appears to have been partially achieved by altering the way the statistician measures prices, delivering a false sense of security, and also the economic impact of lower prices we have all paid for imported goods from China.

On top of this, the impact of wage growth was surprisingly moderate in an environment where first the building sector, followed by the mining sector, bid up rewards for employees. This moderation was largely a function of productivity expansion, which limited unit price rises caused by higher labour input costs.

Well, that game is now well and truly over. Wage growth is no longer being matched by productivity gains and prices for everything appear to be well a truly on the way up, with an inflation target of between 6 per cent and 7 per cent not looking unreasonable by mid 2008.

Briefcase expects the numbers for the March quarter will be a nasty shock, showing much worse inflation than feared. The fact that the Reserve Bank considered a 0.5 per cent rise at its last sitting indicates that the governor fears the sort of breakout of which Briefcase now speaks.

Housing costs were already rising last year as a result of a buoyant market, lifting rents and house prices, but the cost of servicing debt during the past six months has risen by more than 10 per cent per annum as interest rates rise.

These financing costs will surely flow-on to further lift rental costs as 2008 proceeds. Prices more generally have also begun to climb, with higher grain and fuel costs filtering down to bread, pasta and other groceries.

•••

Briefcase gets the general impression that many businesses opened their doors in January and lifted prices across the board. Down at your shopping street for instance, the hamburger-to-go which cost $6 in December now costs $7.50, the toasted sandwich with perfunctory lettuce leaf and grated carrot, which was $8.80, is now $12.20, and so the list goes on.

I am sure Briefcase readers are a more observant bunch than the general run of the population, so I would expect you are also seeing this effect in your weekly and daily shopping round.

In general, inflation is an insidious rot in an economy, reducing the value of savings and making pricing much more difficult and uncertain for businesses. Hard assets, such as property and gold, will usually perform well, but the Australian residential property sector is more than likely to see a severe pullback this year as higher interest rates force more stock onto the market. Intriguingly, most of the commentary seen in the daily press quotes real estate agents, who can be relied upon to give a positive spin on events and generally to talk the market up.

As outlined last week, Briefcase believes the Australian residential and small industrial/commercial property markets will come under some considerable stress this year as a weight of sellers overwhelms buyers. So far, the statistics support an increase in sales activity, but stale bull buyers are still standing up to take the stock. Briefcase expects that the buyers will dry up and that the property market will look a lot worse by mid 2008.

•••

Property developer and funds manager Mirvac’s first half 2008 operating profit of $213 million or 21 cents per share is about 60 per cent of its projected full financial year 2008 result. The shares are now trading below stated net tangible asset backing of about $4.02 per share, which should provide some support and limit further downside risk

The main risk for Mirvac, and it is a large and growing risk, is its exposure to Australia’s residential property sector in an environment of rising interest rates. About 85 per cent of Mirvac’s $14.3 billion development portfolio is residential, but the company also runs a property funds management portfolio of $13.5 billion, providing a strong level of annuity income to offset the more cyclical, build and sell business.

Mirvac is likely to experience some stress from its residential sales this year, as interest rates begin to bite, even in the boom market of Western Australia, where many of its projects have previously sold off the plan. Overall, however, Briefcase sees Mirvac’s residential portfolio as being generally sound, yet there are areas of potential weakness, particularly the Queensland Gold Coast.

•••

Mirvac’s share price has fallen from $6.20 to below $4, despite the Dubai-based and UAE government-controlled Nakheel Group recently lifting its stake to 8 per cent after taking a placement at $5.20 per share. Mirvac’s growing relationship with Nakheel offers it ongoing opportunities for joint venture projects in Australia, but one would hope, not in Dubai, which Briefcase sees as a disaster waiting to happen.

Mirvac has fallen to the point where it trades with a prospective price-to-earnings ratio of 11.2 times, offering a yield of 8.6 per cent. Mirvac’s gearing, calculated as debt to equity, is 46 per cent but is 30 per cent on the basis of debt as a percentage of total assets, which is a more common measure in property circles.

The company’s managing director, Perth-born Greg Paramor, has seen it all before and his company is in a strong position to take advantage of distress selling in the sector, which could set Mirvac up for a strong period of growth over the long term.

 

• Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au

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