Key Points
- The Dark Side throwing in the towel?
- Shanghai finally joins the Global Bull Market
- All Ords breaks 5500 and joins in too!
- BHP is a Paradigm SUPER stock on oil and copper
- Expansion continuing with ASX XSR small resources up 8% in July
- Dawes Points 2014 resources portfolio up 64% for 1 January - 30 July
- Gold in super bull market with demand rising from India and China
- Oil and gas exploration activity in Australia stepping up
The Dark Side of Pessimism, Commodity Price Terrorism and China Envy appears to be finally throwing in the towel to surrender to the massive tide of global economic expansion as the aspirations of the world's rising middle classes prevail. Expansion with record levels of global cash to fuel it.
And what an event this is. It is one to savour and to pass on to your grandchildren. I have said that before but it is and it is all happening according to the Dawes Points script. It is crystal clear in the markets now that China is not collapsing, the European banking system is not melting down and the US economy is not falling into the Greater Depression.
If the world has done this well despite the pessimism, what will now happen as the Dark Side changes its view? Are you ready for it? What will happen with the extraordinary high levels of cash on the sidelines flow back to markets? And from the bond markets? You have been forewarned so are you fore-armed?
The Dark Side has for years churned out a never ending torrent of warnings based on China slowing or Europe collapsing and the ensuing oversupply of commodities that was going to push down iron ore, copper, coal, LME metals, silver and, of course, gold. The Super Cycle Bull Market in commodities was over and also was the strength in the A$. Oh yes, also buy US T bonds! And build up cash!
And all this has proven to be false prophesy. What can you say about their professionalism?
But the false prophesies have been enough to all but destroy the capital markets for resources stocks along with careers, opportunities, livelihoods and wealth. Yours and mine. FOR NO REAL REASON!
And we still hear it. Investors should build up cash and chase yield. Not capital growth. So why then have the Russell 2000 Small Caps and the S&P600 Small Caps done so well and have led this market up since the March 2009 lows?
The market facts tell it clearly.
|
Mar 2009 Low
|
30 July 2014
|
% change
|
| S&P 600 Small Caps |
131.54
|
475.25
|
360
|
| Russell 2000 Small Caps |
355.91
|
1146.57
|
321
|
| S&P500 |
695.27
|
1970.07
|
282
|
| Dow Jones 30 |
6709.61
|
16880.36
|
251
|
And Google, Tesla and Face Book are hardly high dividend yield stocks.
So in great contrast to these strong highs, resources stocks are priced for the end of the world which is clearly not happening. So if not, then there should be some `normalisation' in the terms of Wall Street Wallys. That is, a major upward rerating of resources.
So, where to start with the plethora of positive market signals in July.
We could focus on any of the following:-
Stock Markets
| New All time Highs |
So Close to All time Highs |
Pre 2008 downtrends broken |
2011 downtrends broken |
| US |
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| Canada |
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| Germany |
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| India |
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Sth Korea |
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UK |
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Japan |
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Singapore |
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Taiwan |
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Europe |
And how about these for commodities
| New All time Highs |
So Close to All time Highs |
Pre 2008 downtrends broken |
2011 downtrends broken |
Waiting |
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Palladium |
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Silver |
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Bauxite |
Moly |
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Platinum |
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Cobalt |
Copper |
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Oil |
Zinc |
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Nickel |
Lead |
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Tin |
Gold |
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Uranium |
Aluminium |
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Resources stocks are not reflecting these conditions at all.
And then there is gold. It was covered in the last Dawes Points and gold stocks are performing well.
Just note the basing and reversal in the GDX ETF of the XAU (Philadelphia Gold Index).
Note that gold stocks in North America are still about just 30% of their `normal’ rating against the general market and are turning up again. Big % gains to come.
But the clearest signal is the economic data coming out of China.
The 7.5% pa GDP growth rate is being maintained and the various Purchasing Managers Indices (PMIs) are now all pointing up. Expect an acceleration from here. Overall, China never really slowed overall and never as much in most sectors as the commentators expected, as we saw through the crude steel production data. And the US had 4% growth for June Qtr!
My four visits to China from Sept last year gave no obvious indication of a real slowdown and in fact reinforced my views of an increasingly sophisticated and complex society so keen to improve living standards. And the infrastructure and technology standards are so high that Australia is not keeping up.
With economic expansion in China comes an increase in everything but particularly the demand for energy. In a slower 2013, BP Datashows energy demand only grew 4.4% and took China to 23% of total global energy consumption and 25% higher than the US.
Importantly, gas consumption in China increased 10.6% in 2013 but it is still only 5.1% of total energy consumption in China whereas the total global average is 23.7%. Coal is still around 68% in China and 30% globally. The demand for gas in China has so far to go from this 5.1% to at least 20% to get anywhere near the world's 24% and 30% in the US. This graphic tells us a lot about the economies of China and the USA and the changes since 2006.
Focus on the gas numbers because China will be a major importer of gas via pipeline from Iran and from Russia and can be also expected to greatly increase LNG imports as well as develop its own shale gas resources. China needs to increase gas share from 5 to at least 20% in a growing energy consumption profile over the next 20 years.
See how the US has increased gas by 25% to a level of 30% from just 24% in 2006 and reduced its coal consumption by 20% from 24% to 20%. All from that shameful fraccing!! So much more garbage from the Greens.
Now just look at the markets.
My last visit to China provided strong signals that share ownership in China is not highly regarded. It seems much money was lost after 2007 with a steep index fall of 70%, a rally, then a grinding 45% decline over five years and a retreat to the levels of 2001. No one owns shares anymore. Its all in property and shadow banking high interest loans. Unfortunately the property developers can't quite make the payments on the 25-35% loans so the cash will likely go elsewhere. Shares maybe?
The markets are showing that the bearishness is now turning.
The US$15,600bn market cap Shanghai SEC Index is up 13% in the past year and is on a PER of 10.1x.
The 2007 downtrend is broken after the Index bounced off the 22 year uptrend.
This FTSE China 25 Index ETF is also pushing against the 2011 highs which are also post 2008 highs.
China had been holding back Australia but we are now leading Shanghai and with the break through 5500 the All Ords will now try to catch up the world.
These improvements have been anticipated by some of the better opportunities in the market and are reflected in the 30 stocks Dawes Points Nov 2013 Non-trading Portfolio which is now up 64% since the beginning of 2014. Big gains by LNG (4% of initial book value), LMB (0.8% ibv), AQA(4.3% ibv) and WSA(4.3%ibv) have helped significantly.
Here is the portfolio. Big caps have finally started to move but stock picking in the smaller end has produced stellar results. Much more to come.
Now one of the things that has been embedded in my brain since entering the financial markets is that the market in Australia can only go where the market leader goes. And this is BHP.
So if the market leader is not going higher then the market will find it difficult to move higher.
We all have been bombarded by the iron ore bears who equate the iron ore price with the future of the Western and Eastern Worlds. It affects BHP of course and RIO and then we have the numerous experts who have shorted FMG.
But the operational and production responses and the market action of BHP are not of the character of a company, and hence a market, going nowhere.
Note this extraordinary comment from a local fund manager who told Reuters:-
"At the end of the day, BHP's fortunes are tied to the iron-ore market," said ………., chief investment officer at ………. Asset Management, which recently sold its shares in the miner after holding the stock for close to 15 years.
"The stated strategy of the majors is to squeeze higher cost production out of the market," he said. "We're just not sure that maximizing production is as sensible as they think it is."
So he is sold out. Yet the stock is at 12 month highs so something else is happening.
This is the `Generals and the Maginot Line’ concept referred to in the February Dawes Points.
If the market for BHP is holding up and the iron ore price isn't that bad maybe this something else is happening. How about the something else being copper?
Copper prices have broken the 2011 downtrend and LME inventories are just 144kt for a 21mtpa market and are at 6 year lows.
The Dark Side has tried to tell us that the inventory has just been moved from LME warehouses to others in China and that financing of this inventory will bring us all unstuck. Garbage!
BHP will produce a net 1.8mt of copper in FY15 and at US$7000/t this is US$12.6bn in gross revenue. At US$7700/t this is US$1.26bn more. Escondida and Olympic Dam, each growing.
Now to another something else.
The 2011 acquisition of Petrohawk's Eagle-Ford and Permian oil and gas acreage and Chesapeake Energy's gas at Haynesville by BHP was derided by the
cognescenti at the time as an over-priced and strategically dumb acquisition. Gas prices fell after the acquisition so it was a big joke with writedowns on Cheaspeake's Haynesville assets. Another Magma Copper. HBI. Ravensthorpe. Failure.
But wait a moment.
Look at these numbers for gas which show a doubling for BHPP since the acquisition.
| Year end June (BCF) |
2011
|
2012
|
2013
|
2014
|
| Bass Strait |
107
|
112
|
124
|
109
|
| North West Shelf |
125
|
144
|
131
|
128
|
| US onshore |
36
|
448
|
479
|
449
|
| Other |
137
|
118
|
140
|
153
|
| Total |
405
|
822
|
874
|
839
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| US onshore % |
9
|
55
|
55
|
54
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US Onshore provides almost 55% of BHP Petroleum's gas production but at the current US$4/mmbtu at Henry Hub its not too exciting.
But more importantly however, the unconventional oil and liquids mostly from Black Hawk and Hawkville in the Eagle-Ford shales provided 26% of BHPP's FY14 net liquids output and 31% in the June Qtr at a rate of 28mmbbloepa (80,000bbloepd).
BHPP has advised a 17mmbbl liquids increase for FY15 and it had spent US$3.9bn in FY14 to achieve this. So taking a steady growth of +2.5mmbbloe per qtr growth rate to give just 15mmbbloe extra in FY15 then the June Qtr FY15 could be producing at a rate of over 60mmbbloepa (170,000bbloepd). What will FY16 look like? Can't really know today but BHPP has said 200,000bblpd by 2016(>70mmbblpa) so expect higher numbers in FY16.
What may be known is that BHPP is probably getting one year IRRs of over 70% and 60mmbloe pa gives annual revenue of US$6,000m and at a conservative 50% EBITDA margin this adds a lot to BHPP's earnings. Like about US$2bn in FY15 and US$3bn in FY16.
The technology changes in drilling are bringing down drilling costs, improving reservoir recoveries and boosting returns. BHPP `is testing high-temperature gels for better proppant transportation, different stage spacing to maximize stimulated rock volume, and reservoir modeling to simulate stress capture and optimize well sequencing.' (UOGR April 2014) BHP also reported that field trials achieving are 10-40% higher than production for comparable surrounding wells.
The rapid technology changes in unconventional oil production (now really a `manufacturing’ business rather than exploration) are suggesting increases in oil recovery from about 3% to as much as 6%, with about 50% recoverable in Year 1. Getting 400,000bbls @US$100/bbl in Year 1 is US$40m revenue with $8m op costs for a US$10m well is over 100% Year 1 IRR. Try 150%. And BHP is spending US$4bnpa. The above BHP numbers might be low.
So here are two major Divisions of BHP in cashflow growth mode that will offset any earnings weakness from any lower prices there in iron ore with its 10% higher FY15 225mtpa output, costs reduction and revenue of US$20bn.
It seems that the world has just focussed on BHP's iron ore and ignored Copper and Oil. BHP's share of All Ords market turnover has been at the lowest level for over 10 years suggesting it is very much underowned. Turnover in recent weeks has jumped up sharply suggesting BHP will again lead the market higher.
Other markets are giving BHP a better ranking so have a look at BHP in US$. More action than in Australia, possibly.
The raison d’etre for the establishment of DawesPoints in 2012 was to advise clients and the world in general that the real economy was operating at very different level to the financial economy. And that the real economy was doing far better than the financial community has been giving credit for.
The continual reference to the US markets has been a core activity of DawesPoints because these are far more liquid markets with vast numbers of buyers and sellers with different goals, views, responsibilities, time frames and of course attitudes. The Australia market appears to me to be concentrated with strong convergent groupthink views and guided by a generation of advisors investors with contrasting time frames compared to the real economies' requirements. Risk averse commentators driving investors away from equities and to overweight positions in bonds and cash.
The Australian investment market of course has had the luxury of being able to invest in a vast number of overseas markets with stocks such as Apple, Google and Tesla not available in the local market. So rightly competition for capital is substantial. However, it is a pity bank deposits have won this section of the race with their A$1,606bn balance.
How is it that our Australia prefers to back the banks and mediocrity or overseas companies rather than backing its citizens in their visions and endeavours? Why would you back XYZ Bank Ltd to invest in 4.8% mortgages rather than to invest in Ken Everyman who has uncommon drive and a great idea about how to produce and sell a better front door lock? What about Dr Phil Brown and his biotech innovation in a field that Australia is an acknowledged leader (did you know that the local George Institute is THE leading medical research unit of the world!!). Why indeed would you not invest in Bill Brilliant who has a copper deposit that he has assessed as worthy of further development? Or John with his iron ore opportunity? Or Frank with the acquisition of a major exploration target from large international mining company for whom the target no longer met corporate goals. Real ideas, real drive and real assets from real people.
Australia does have the world’s largest listed mining company in BHP and a range of other and its banks are world class with all the big 4 with AA ratings
The scope of this is vast and extraordinary. From gold to iron ore from new mining technologies to unconventional oil and gas. Opportunities everywhere.
And yet still the large investment banks are still vying for the title of the most bearish. How many of them have even been beyond Hong Kong into China. Not many, it would seem.
And the fixation with a lower iron ore price and the collapse in the steel industry in China as it goes to yet another new record high (yes, new record of 843mtpa in June!!). Oh, puulease.
So what
is really happening now? The Bear Case of overwhelming debt leading to a US Depression with European banking collapse and China falling over has very simply failed to eventuate. You can say QE and other injections of liquidity have prevented the collapse and that unless we get more then it will still happen. Maybe.
The much proclaimed collapse in commodities hasn’t arrived yet and apart from the ridiculous preoccupation with the iron ore price it appears it won’t.
What is going to happen to these people who have been preaching Armageddon and worse? And to those who have listened?
I saw some `unverifiable’ data from a US columnist that showed that ten major global economies (including US, UK and Australia) had current savings rates in excess of 40%. No wonder global growth has been slightly anaemic.
But what does A$1,606bn in bank deposits suggest to you? How could Treasury, most banks, the disgraceful `asset allocators', a growing army of risk averse financial planners and scared ordinary people with the conventional wisdom of Cash is King be on the right side of the market? A thirty year bull market in bonds has certainly sucked in everyone, especially governments who think that the markets will always be there to take over priced paper.
But note that the tide has already turned with major US bond funds reporting a full year of redemptions as the risk of holding low yield, balance sheet-challenged government paper just keeps growing.
And here, the latest RBA data shows that although total bank deposits are still rising ( up 0.7% to a new record A$1,606bn) in June the Term Deposits category had the biggest ever monthly fall (A$7.9bn) to just A$529bn and at -1.5%, the largest % fall since deposits began to rise sharply in 2007.
Funds flowing from bonds and term deposits is now well underway. Into investments, property and soon into retail consumption. For us that is into equities and commodities and into resources equities (read small cap resources stocks!).
Well if you are reading these DawesPoints you know these have been my views and you have had it consistently straight and true.
Bull market for resources and commodities.
And these views haven't changed in the past two years.
Now some more facts for you to consider.
Resources sector bottomed in the GFC in Nov 2008 and the broad markets Dow, S&P, All Ords, FTSE and DAX bottomed almost 4 months later in Mar Qtr 2009.
Say that again. The Resource Sector (XMM.ASX) bottomed in Dec Qtr 2008 and the broader market bottomed in March 2009.
So technically we have been in a bull market uptrend in resources for almost six years now! Hasn’t felt like it has it?
The resources market rallied into April 2011 then weakened into June 2013 for the first major pull back. A 53% fall was some pullback. Ouch.
And 71% for Small Resources was ,.. er,..er,.. um,.. some pull back. But it is bottoming!
The poor old gold sector after making a magnificent 230% rally from the GFC into 2011 then fell 80.0% to Dec 2013. Mere details! And of course the small caps became microcaps and then nanocaps and worse. Quite few 95% falls here. More than OUCH.
All these share price collapses for no real macro economic reason. Just misinformation, groupthink and fear.
But what value has been created!!
And strong stock and portfolio performances in 2014 reflect that. So much more to come.
I have referred to the `stealth’ bull market in Australian oil and gas exploration that is well underway now. The new LNG projects in Australia will be export conduits for many new gas fields in Australia and will change the entire industry.
I particularly like the key Cooper Basin stocks (BPT, DLS and SXY) and also those in the NT and parts of WA. Hopefully a full report might be available very soon. The implications are very great and the opportunities will be very rewarding.
There are hundreds of companies with quality projects that need to be financed and I am happy to recommend dozens of them. This is going to be an extraordinary Bull Market for the next decade!
So the opportunities in Australia now start with our preferred leaders.
BHP and FMG (SUPER stocks) with WPL, OSH, STO, WSA, ORG as leaders.
Onshore oil and gas led by BPT, DLS, SXY in the Cooper Basin and then AJQ, CTP and REY.
Gold stocks NCM, NST, ABU, GOR, SLR, SAR, BLK
Copper stocks CDU, PNA
Industrial metals TRO, AMI, IBG,
Technology metals ORE, ALK, LMB, VXL, KNL, CNQ
Metals explorers SIR, CZI, KGL,
Many more as this market moves up, as we discover new opportunities and as relative values warrant switches.
So what happens now for the supporters of the Dark Side?
This is a very important question.
If the end of the world hasn’t happened by now what might be the options for them?
- Wonder what to do with A$1,606bn in bank deposits?
- Get even more bearish?
- Actually go to China and see it first hand rather than pontificating with propaganda of envy?
- Look for undervalued sectors?
- Concluding resources and Australia look very appealing?
All of the above.
And that suits us just fine!
I own shares in BHP and FMG, STO, DLS, AJQ, CTP and REY. NCM, NST, ABU, GOR, SLR, SAR, CDU, TRO, AMI, IBG, ORE, ALK, LMB, VXL, KNL, CNQ and CZI.
7 August 2014
Sydney
Similar but still nascent changes seem to be underway in ASX Small Resources and also in the XMM, with prices still falling but volumes and market share increasing. All good tentative signs.
The Dawes Points 3 December 2014 untraded gold stock portfolio provided a 73.6% return for 13 months to 31 December plus almost 2% in dividends.
Here is the proof.
Great gains by overweighted leaders Northern Star and Evolution together with half weighted emerging companies Blackham, Saracen and Gold Road gave the portfolio most of the performance and it outperformed the ASX Gold Index by about 20 % points in value and about 0.5% in yield.
It is easy to say that the local gold sector has done well because of the weaker A$ but the A$ gold price has been around A$1,500/oz for the past five years. The recent moves above A$1,600/oz and last week's surge to A$1,588 will certainly help sentiment.
The gold price at A$1,500/oz has made good earnings for many companies and I expect that the Dec Half of 2015 will bring even more gold production growth, lower operating costs and higher earnings.
Expect many gold producers this month to put out early advice of good production stats ahead of the formal quarterlies.
But it is not just the A$ gold price that has made these good market performances.
Real effort, ingenuity and investment is involved in this local industry and here is where the industry is going with the production growth results very clear in WA which has consistently produced 65-70% of Australia's mined gold.
The longer term appears robust for all Australia.
In assessing the Gold Sector Portfolio, emphasis was placed on the S&P ASX 300 Gold Index to ensure investors were looking at visibility and liquidity for most chosen stocks.
However, since the ASX sold its index business to S&P the resources market has never been quite the same. The Gold Index was discarded and not resuscitated until about 2005 and then was backdated.
The actual XGD Index was recently critically reviewed by Dawes Points to analyse its effectiveness.
This index has been found to be an appalling collection of gold, non-gold, local and foreign listed stocks that gives no real reflection on the activity in the Australian gold industry of the past decade.
So coming to the real action in the ASX Gold Index today we have a tale of two sub sectors:-
Domestic gold producers; and locally domiciled companies with offshore gold production.
The ASX 300 Gold Index currently has 22 stocks. Ten are gold-only plays domiciled in Australia and operating mostly Australian gold mines. Eight are Australian domiciled and operate mines offshore. Two are foreign domiciled and have all or mostly foreign gold mining operations. One is a diversified miner with local gold production and one is a diamond mine developer.
Look at this.
First of all, note the June 2013 low that I have often mentioned! An unweighted index of up to ten Australian local producers is up 165% since that low.
The eight offshore producers are down exactly 50%. The Index itself is up just 28%.
Where did you want to be in this index? Clearly with Australian gold companies producing locally.
The other four stocks in this 24 stock universe have little or no relationship with the Australian Gold Index.
What a misallocation of resources. What would be the interest in ASX gold stocks be if the ASX Gold Index actually reflected these strong gains and the activity in the Australian gold industry itself!
ASX investors should be able to invest in confidence in Australian companies involved in the gold industry.
Australia is the second largest producer of gold, after China, and the opportunities should be large and many. A decade ago, almost two thirds of Australia's gold production was owned by overseas domiciled gold companies. Recently, substantial gold production assets have come back to Australia through sell downs and acquisition by Northern Star, Evolution and MetalsX.
Everyone should be investing in this production growth and not, as suggested by the ASX 300 Gold Index, in some foreign domiciled offshore producer and certainly not in an offshore uranium prospect. Or in a coal miner, iron ore producer, or a gas company.
Actually, the story of these Australian gold producers gets better.
These terrific ten Australian gold producers make up over 90% of the XGD turnover and as noted above this is now back up to around 2% of All Ords turnover.
Makes the current makeup of the XGD Index look silly.
Well, my 2016 portfolio will still emphasise most of these top ten (eight actually) with a few more that should soon come into the XGD:-
Only three of the offshore producers make the grade for the portfolio.
I have added some emerging stars to give us the Dawes Points 2016 Gold Stock Portfolio for a A$100,000 portfolio. $40% in the larger stocks, 30% in mid caps, 20% in growth opportunities and 10% in minnows.
I am taking the 31 Dec as the start date so let's follow the performance over the year and compare it with the 2015 Portfolio.
I would like to refer to two other minnows that wouldn't fit in the Gold Portfolio but could provide some excitement in 2016. Mustang Resources (MUS.ASX) has some very high quality projects in Mozambique that include rubies and diamonds.
Alt Resources (ARS.ASX) is a recently listed explorer with an outstanding copper porphyry target near Cooma in the Snowy Mountains on NSW.
The US Fed has begun its interest rate hikes as that economy strengthens. The evidence is clear that this is a sub normal recovery but the deleveraging has been substantial at personal and government levels and even the US Budget Deficit seems to now be 40% lower than just a few years ago. Savings rates around the world have improved balance sheets everywhere. The US$18trillion debt is still there but the bond market is still signalling that higher yields are in store over the next few years.
Rising bond yields after such an extended period of easy money will be reinforcing the probabilities of the end to the deflationary days and a pick up in inflation.
Over US$90trillion of capital is tied up in government and corporate bonds. This is a massive source of capital and when coupled with the global cash levels, there should be strong flows of capital out of cash and bonds to gold when sentiment changes.
US 10 Year Bond Prices - Weekly
The market for gold is now driven by the Love Trade for jewellery in India and China and is likely to do so for quite some time.
From this graphic it is easy to see that most of the world's 170,000 tonnes of gold is held as jewellery and demand for gold into India is insatiable.
China in 2015 according to Koos Jansen at Bullion Star had another record year of imports (~1,200tpa) and domestic withdrawals (2,405t ytd) through the Shanghai Gold Exchange.
World mine production is only about 3100t so between them China and India absorb all mine production.
Coin demand remains robust and silver coins mint production in North America has maintained the very high levels of 2013 and 2014 to meet this strong demand.
This Supply and Demand for Gold for the Next Ten Years strongly suggests a tight market for gold will exist for quite some time.
You will be familiar with graphics of the Philadelphia Gold Index (XAU) that is showing an index level that is almost as low as that at the US$248/oz low in 2000.
My reading of this indicates we are near the lows in these major North American gold stocks and if the market is completing the Wave 2 correction then the upside should be strong and should follow what we have already seen in the Australian Gold Production Sector above.
The market is currently all about sentiment and the sentiment has not yet turned favourably towards gold but that change cannot be too far away now and the response could be rapid.
This strong view for North American gold stocks is supported by the very long term graphic for the Barron's Gold Mining Index which goes back to 1940.
An excellent long term uptrend is matching support of 2000 and is also about the same as highs in 1969!
Readers will probably be also familiar with the XAU vs the S&P500 whereby gold stocks there have fallen 90% against the S&P500.
We can look again at the S&P500 against all commodities (CRB Index) and extreme is the only word that can apply!
And market sentiment shows it very well.
Finally, four major indices that don't look as if they are about to crash.
Markets are always difficult to assess but true value always wins.
You can contact me at bdawes@psec.com.au or +61 2 9222 9111.
I own: NST, BLK, GOR, MLX, TBR, DRM, MML, RSG, CGN, GEE, TNR, TYX, MUS, ARS
Edition #44 
You can draw some very interesting conclusions here about sector rotation.
So when looking at Dongfang Modern here is what you find.
First of all I hope you expect that the Due Diligence carried out on this company is of a high standard. The Legals were overseen by Piper Alderman and the accounts were reviewed by PKF Lawyers. The accounts have been audited since 2009 by PKF Hong Kong so the data is reliable. The cash on the balance sheet is actually there!
I have made mention previously that this has to be the most impressive set of accounts I have seen in my +30 years.
This company was set up in 2005 and in 2008 the current Chairman injected about US$6m to acquire an 89% holding.
This was the last capital injection to the company. No more equity and no debt at all.
The plan was to acquire as many plantations as possible and by 2012 it was 9 plantations over 4500 hectares and by end 2015 it will be 19 plantations over 9,000 hectares.
That initial investment of US$6m in 2008 has probably provided the highest multiyear IRR ever recorded. After A$57m (A$ equivalent) earnings in 2014 DFM's June 2015 Interim showed Retained Earnings of A$216m. All done without additional equity capital and without debt.
These numbers are attractive and make interesting reading. 2015 and pre 2015 are PKF numbers and the forecasts post 2015 are Dawes Points alone.
The company is now probably the largest citrus grower/harvester in China with about 1.3% market share by revenue in a very fragmented industry. So many industries in China seem to be highly fragmented and the aggregation and consolidation process there has probably twenty years more to run. These are important business drivers and help to show another side of China.
Paradigm carried out major financial due diligence and modelling and made a site visit to several of the plantations.
Detailed forecasts were made based on all available published information and then some conservative assumptions were made.
Growing and harvesting citrus produce isn't all that far from something like coal mining.
You have a resource (trees) that should give a certain grade (harvest) with output of net fruit (grade) and at an expected recovery (yield). The selling price is the market price so revenue is saleable output time's price. Costs are roughly fixed so improved yields and productivity improvements can increase volume without fixed costs rising. Dongfang is hoping improve yields by about 4-5% pa for the next few years. So output should rise and costs rise less so.
Output will also rise as additional plantations are acquired.
Prices have been rising over the past few years too because demand has been stronger than supply and supply growth.
Dongfang's operating margin has been over 40% for the past few years and it expects to will stay high.
A study of future earnings for the next decade based on increasing tree volume through plantation acquisition, rising labour cost (which they are doing), modestly improving harvest yields and marginally higher product prices gave some quite astounding numbers.
Dongfang was #2 by sales revenue in 2014 with 1.2% market share after AIM listed Asiatic Citrus but the increased output to 230,000tpa in 2015 by Dongfang coupled with a couple of operational issues for Asiatic Citrus should now make DFM #1 with about 1.3% market share.
Market leader with 1.3% market share reinforces this fragmented industry concept.
Dongfang would like to go to 4-5% market share over the next several years so that implies organic and acquisitional growth
The numbers for Dongfang as assessed from public information by Dawes Points look like this with historic data in RMB and converted to A$ at historic rates or using the IPO Prospectus forecast of RMB 5:A$1.00.
This Valuation Matrix shows DFM's P&L and Balance Sheet in one and also gives a valuation target for DFM.
Note three years earnings history, the current year estimate and three years forecast for EBITDA on a product basis (note the very low D&A levels) and no interest cost.
Forecasts are deliberately conservative on prices, output, acquisition growth and costs but still show earnings rising steadily rather than surging.
The staff levels are low (only about 100 people) so administration expense is low and all harvesting is by contractors so EBITDA for each product is net cash. Note no tax is payable on earnings from agricultural food production and that almost all earnings have been reinvested, with capex mostly into acquisition of additional plantations.
The balance sheet is cash-rich without debt and EBITDA against estimates of sector assets gives a Return on Investment (on book value) of 30% overall and almost 100% for tangerines.
If we put each product division on 5x EBITDA, and add the cash, the appraised value for DFM is over A$500m and A$1.47/share compared to the IPO price of A$1.00.
Note that the forecasts have used 5:1 on the exchange rate, well above the current level, so A$ earnings would be higher with today's 4.62:1.
I expect over time that the market will give a much higher rating after DFM delivers on its plans.
Dongfang Modern is one of the largest China operations listed on ASX and shouldn't be the last.
If you came into the IPO, (and thanks for your help), you probably only came in in a modest contribution.
If you haven't, the hard work has been done so you should now be able to come in at lower entry risk to share the gains.
Barry Dawes
19 October 2015
I own DFM and Paradigm was the lead manager of the DFM IPO.
Edition #42 
Iron ore has seen a 50-60mt global stock drawdown while crude steel output has remained firm. Port stocks have fallen back to 80mt after reaching 110mt earlier in 2015 and steel mills’ stocks are well down. Some restocking is coming.
Then we look at some other simple data like Qtly annualised GDP growth and Indexed GDP. No economic collapse here.
Source: China National Statistics
And then something even simpler as average annual personal disposable income in China. At <5 RMB :A$ this is ~A$6,000pa in the cities and just ~A$2,000 in the country.
Source: Dongfang Prospectus
China is growing and its citizens are becoming wealthier.
Diets are changing. More protein. More fruit and nuts. And less cereals.
Source: Dongfang Prospectus
So demand for higher quality, unadulterated, clean healthy food is rising. So are prices - as demand can’t match supply and flows into imports.
Source: Dongfang Prospectus
You are all familiar with the 100m people moving from rural areas to the cities. Well you might like to imagine that farm food output suffered somewhat and led to rising food prices. The PRC government, eyeing their remaining 800m farmer supporters, reacted as true agrarian socialists by exempting agricultural food production from Enterprise Income Tax and personal income tax and VAT. At least until 2025.
So now you have a major market of 1400million people that just wants more and better food.
Having 800 million individual farmers means a lot of individual farms. Try about 10 million!
So lots of little inefficient farms. Fragmented industries I think is the term.
Now how to play it.
Here we come to Dongfang Modern Agricultural Company.
Could it get any better?
This company was set up in 2005 and in 2008 the current Chairman injected about US$6m to acquire an 89% holding.
This was the last capital injection to the company. No more equity and no debt at all.
The plan was to acquire as many plantations as possible and by 2012 it was 9 plantations over 4500 hectares and by end 2015 it will be 19 plantations over 9,000 hectares.
In calendar 2014 DMF earned RMB 315m ( ~A$56m) and in 2015 this should be over RMB 370m (~A$75m but over A$80m at the current exchange rate). How many Australian companies make this amount of earnings? And at a 43% margin? Without any debt?
The company acquires uncapitalised plantations from village cooperatives and manages them professionally. It then takes the products that were generally suitable only for local town markets and sells them in high volume premium markets in supermarkets and hotels for double the price.
Margins are over 40%. And no tax.
The villagers are happy. They get to sell or lease out their plantations and still get to work as harvesters.
The PRC government is very happy because plantation productivity is significantly better and output is rising. Food quality is improved. Food adulteration risks are lowered. Imports reduced.
Shareholders are very happy because the returns are strong and the risk and volatilities are low.
The returns on paid up capital of just ~US$10m are huge while the returns on shareholder funds which includes RMB 1,000m in retained earnings (~A$180m) are over 30%.
Can you find a better company track record anywhere? In any industry?
Taking the next step, DFM is the second biggest producer by revenue of citrus in China. Produces over 200,000t with just over half being tangerines (mandarins to us) - which is more than Australia’s total of mandarins.
It has about 1.1% market share in these very fragmented industries. Aims to have a much bigger share over the next few years. Wants to be the market leader.
So there. Market leader in the world’s largest and rapidly growing consumer market producing a consumer staple that is in rising demand.
High margins, PRC Govt support in almost everything it does, no debt, and 10-15 years of growth ahead.
What more do you want?
The Shanghai and Shenzhen markets are volatile but have a look at some more sedate alternatives. These ETFs might give you a better idea of listed stocks in China. Not overextended.
I can only conclude that those who gave us warning of the US Greater Depression in 2009 and the Collapse of the European Banking System (over 2009-2015) are just as accurate on the Collapse of China (2010-2015) and that over the next 12 months all those in the market places now sitting on vast hoards of cash (A$17.17bn here in Australia, >RMB 100Trillion (US$18tn) in China and so on all around the world) will be in buying all these stocks.
Stock markets have been climbing a wall of worry for years now and many investors are out.
Many funds are loaded up with ridiculously overpriced and very dangerous bonds or are sitting on mountains of cash.
Meanwhile, so many indices around the world are at or very near all time highs while the bears keep calling the next Crash.
And just think. Half the world is already sitting cautiously in these highly defensive investment positions and 10% has been (we in the Resources Sector)thumped by falling commodity prices. 40%, especially in Asia, is just having a great time. Corporations also have mountains of cash too.
And just like Sydney property sellers are finding, the supply is just not there to quickly get back into the market.
So think about China just beginning to hit its straps as hundreds of millions of increasingly wealthy consumers demand more and higher quality products. And as industry and commerce utilise all of China’s amazing new infrastructure that is assisting with the consolidation of its many internal markets. We are seeing the rise of hundreds of well positioned growing companies who are just totally unaffected by what Janet Yellen thinks.
Dongfang Modern is one that the ASX is lucky to get and I am sure there will be many more quality Chinese companies offering ASX investors an eye and a dividend link into China.
So don’t delay. Fill in that application form or contact me - 