Want to learn the biggest lesson of 2016? Look no further than commodity prices. The first 10 months of the year have seen an extraordinary rebound in sentiment towards commodities, particularly coal. There was a lot of money to be made as well as an important lesson to be learned.
But first, let’s set the scene.
Successful contrarian investing involves going against the crowd. And sentiment is a measure of what the crowd is thinking. How to measure sentiment? One way is to read media articles, particularly newspaper headlines. This gives us a qualitative insight as to what stage sentiment is at.
Stage 1: High Uncertainty and Investor Hatred –
At the start of 2016 miners and the contractors who service them were the most out of favour part of the market. Uncertainty as to whether many mining operations were a going concern was rife. A large chunk of the best performing fund managers from 2012 to 2015 had a simple and effective strategy. Short mining, long everything else.
Sentiment couldn’t have been much worse during the first quarter of the year. And of all commodities, coal seemed to bear most of the brunt of this negative sentiment. Its price had been on a downward slope for years.
Headlines in the Australian Financial Review (AFR) during the first quarter of 2016 included “Coal set for dramatic shake-out”, “Australian coal ‘high risk’ on exports”, and “China coal demand tipped to fall further.”
Perhaps the bell ringing moment was an AFR article about Chinese coal miner Yankuang establishing an e-commerce platform. Its new goal? To sell Australian beef, milk powder and vitamins to mainland Chinese consumers. In China, a tonne of coal had become cheaper than a tonne of water.
Negative sentiment led to valuations that implied disaster scenarios. A number of mining and mining services stocks were trading at large discounts to book value. Some were trading at cash backing or even less. And this provided the opportunity for those with intestinal fortitude.
Stage 2: Disbelief, Followed by Panic Buying –
As mining stocks and commodity prices began to rally, the initial market reaction was disbelief. In March, one large broking house believed that the rally was running ahead of reality and downgraded a number of its recommendations.
Fast forward to today and sentiment is turning. Brokers have almost universally revised their coal price forecasts higher. Much higher. Anywhere from 25% to 65%. Just a month ago, the above mentioned broker materially upgraded its commodity price forecasts as well as its recommendations for those same stocks it had downgraded six months earlier.
It’s as though Mr Market is saying “I can’t believe the coal price is going up, but I’d better buy some coal stocks in case it goes up more.” AFR headlines in September tend to support this view. These include: “Panic buying: coking coal prices surge”, “Temporary coking coal rally might hang around for a while” and “New Hope cautious on coal price rally.”
Stage 3: Future Euphoria?
Despite the coal price rally, there are a few coal bears hanging around. Should these bears capitulate, we could see them provide the fuel to drive the rally further.
Many of the fund manager stars of 2015 have now started buying mining and mining services stocks. Perhaps not so much because they believe their future prospects are bright but because they don’t want to risk not owning them as commodity prices rise. While sentiment is slowly turning positive, it is not quite at euphoric levels yet.
The Biggest Lesson of 2016
The final lesson, then, is an old one: Wait and see is not an option. Many investors wanted to see a recovery in the coal price before buying coal mining stocks. By the time that happened, share prices had already tripled and more.
“Investors hate uncertainty” is something you will frequently read in the financial press. That may be true in general. But when is the future ever certain? It is the perception of uncertainty that changes, rather than uncertainty itself. If you want to be successful, investing at times when the future seems unclear is essential.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.