Right here right now - the biggest themes driving markets are electrification and decarbonisation - which are really 2 sides of the same coin.  And with the global resolve now clearly past the inflection point, these 2 themes are likely to be the dominant drivers for most of this decade.

So far, in an effort to gain exposure, Aussie investors have stumbled from graphite to cobalt to lithium to nickel and then back to lithium again.   However, there is an emerging viewpoint that copper could be the surest way to gain exposure to the enormous electrification opportunity.  For example, Goldman Sachs recently released a piece of research titled: Green Metals: Copper is the New Oil.

Given that the Australian market is renowned as one of 2 global resources hubs, it would be reasonable to assume that there would be a host of copper producers listed on the ASX    However that is not the case. If we exclude BHP and RIO - whose main earnings come from iron ore - there are only 4 ASX listed copper producers. Over the past decade, a combination of corporate activity, low copper price, increased fiscal discipline and depleted ore bodies has left us with just FOUR ASX listed copper producers. This is extraordinary for the most widely used base metal on our planet.

Of the 4 producers, OZL and C6C are both trading on PERs in the mid20's.  SFR would appear superficially cheap, however the DeGrussa mine is scheduled to be depleted sometime during 2022. 

This leaves Aeris, which our funds have been steadily accumulating on a PER of <3x.

Aeries recently came to life on the well-timed and equally well priced purchase of the Cracow gold mine from Evolution in 2020.   In fact so well timed and priced was the acquisition, that in the space of 12 months they have been able to completely pay off their debt and are now generating strong surplus cashflow. But it is the Tritton Copper mine near Cobar in western NSW that has piqued our interest. 

The Tritton min has been producing copper since 2005.   During this time it has produced over 320,000 tonnes of contained metal.   Over the past decade, it has produced between 23,000 and 30,000 tonnes every year.   It is forecast to produce around that amount - ~23,000t - this current financial year, at an AISC of $3.75 per lb.   Yet despite this long term record, the stock is trading on a consensus average PER of 3x over 2021FY to 2023FY.  

Clearly the market has concerns.  From our analysis, there are 2 major investor issues: mine life and hedging

Mine Life

The last stated reserve of 86t contained metal equates to a little under 4 years.  So on the surface this would appear an issue.   However, there are important factors that make it highly likely that the mine will be operating for many years to come.

The first of these is highlighted by existing resources (as opposed to reserves).  At 250,000 tonnes of contained copper, this is equates to more than 10 years at the current production rate.   At the current high copper price, we would expect a solid and ongoing conversion of resources into reserves    But there is an even more important point.   Reserve definition drilling requires a much higher level of saturation.   Most mines of this nature drill the ore body to sustain mine plans (only) several years out.  As the mine goes deeper, infill drilling of known resources will continue to add to reserves.   The best demonstration of this is to review past reserve statements.   In 2013, total cu reserves were 126,000 tonnes.  Since then the Tritton mine has produced nearly 190,000 tonnes and counting.

The second factor that adds to our confidence is that Aeris has reported strong exploration success over the past 12 months.  In the coming years we are likely to see additional tonnes from 3 sources:

• Life of mine extensions via mineralisation at depth, South Wing, Budgerygar and the corridor between Tritton and Budgerygar
• Brownfields exploration at Murrawombie, where >5 metre intersections as high as 4% have been recorded
• Greenfields exploration via the Constellation target where the first drill hole spectacularly intersected 20m at 2.4% Cu.

It's important to recognise that for much of the past decade, Aeris has been struggling with low Cu and gold prices and hence has not had the dollars to spend on exploration.  This has changed in the past 12 months, and we would expect a steady stream of positive drill results.

Hedging

Like a lot of companies, when the Cu price rallied hard, Aeris prudently put in place some hedging in the event that the move faulted.   Clearly in hindsight this has capped their short term benefit.  

However the hedging currently in place is modest.   Aeris has locked in 78% for the current quarter (which has only 7 weeks to run) and 26% for the September quarter, both at an average of $4.57 per pound. 

This will still see a strong cash build, whilst also allowing the company to sell part production into the decade high price.    Beyond the September quarter, Aeris is unhedged and will be able to sell 100% of its production at spot, which at the time of writing had pushed through $6.30 per pound.  

Strong Risk-Return Proposition

If prices hold anywhere near the current level, this will see Aeris generate 'super profits'.   If the emerging consensus view is correct, then a combination of 'super profits and limited cu producers may see investors clamour for stock. 

On past earnings, a PER of 9x would equate to a share price north of 30c.   If we flow through the current spot price for copper, then the 'theoretical' valuation is multiples thereof.   .   If the market is being overly cautious, then this is a rare opportunity in a sector that has the strongest of tailwinds.

Recently I attended a UBS hosted virtual China Commodity Tour. In light of the observations that I had made back in a research note to you all in December 2020, I thought it would be useful to provide an update to those views given recent positive trends.

China is not only the world's second largest economy, it is also Australia's and New Zealand's largest trading partner (c. 30-40% of both countries' exports) and its economic performance influences investor sentiment in both economies. In recent times navigating a more assertive China under President Xi Jinping has been a key factor to monitor for investors in Australasian equities. China in particular has proven itself to be very effective at managing COVID-19, which allowed a strong recovery to develop. More recently the pace of vaccinations in China has picked up reaching 200 million shots with the government targeting 40% of the population by July. In terms of macro developments, Q1 2021 GDP growth jumped 18.3% (relative to a year earlier) whilst sequential growth slowed, as expected, to about 2% (quarter-on-quarter). UBS expect this to stay at around 6% for the balance of the year, resulting in a full-year GDP growth forecast of 9%. This mirrors a strong growth recovery in the US being driven by policy stimulus and progress towards a normalization of activity- Goldman Sachs is forecasting over 7% US GDP growth for 2021. Other growth metrics in China remain robust; Fixed Asset Investment rebounded 25.6% in the first quarter, Industrial Production grew by 28% and Retail Sales rebounded 34% (8.5% higher than the first quarter of 2019). Similar trends were evident in property with sales up 64% from where we were this time last year. With Chinese stimulus beginning to recede, growth rates will moderate but real consumption growth should remain robust in the period ahead.  

Key presenters in the UBS tour highlighted a broadly positive demand backdrop but one where the authorities are focused on moderating any excesses. The government is tightening credit availability to property developers to avoid overheating with forecasts of lower housing starts in 2021, although Infrastructure is expected to grow by 6.5-7%. This combination suggests positive steel demand this year (a recent CLSA survey estimated more than 3% growth). Policy makers in China are increasingly focused on restricting steel exports and limiting production due to pollution in a number of key regions, in particular Tangshan. During the past week China removed steel export tax rebates for 146 types of steel products and will increase the export tax on certain steel products from 15% to 20%. With steel exports in China currently annualizing over 60 million tonnes, the government is now clearly signaling a new direction in this area. China produced 271 million tonnes of crude steel in the first quarter of 2021, up 15.6% year-on-year. On an annualised basis this equates to 1.08 billion tonnes. If China maintained this level of steel output for the rest of the year, expectations were that annual production would therefore increase by around 4%. However, following the tour and recent news flow around the removal of export rebates, our base case has now been revised lower and assumes that China will reduce their exports through the balance of this year resulting in steel output growth of only 1.5%.

On the face of it this is a negative for iron ore demand in China with over 80% of output being produced from blast furnaces (a process that requires iron ore at a ratio of 1.7 tonnes of ore to produce a tonne of steel). However, with China withdrawing tonnage from the steel export market we expect other regions to increase blast furnace capacity utilization to make up the difference. Principally this will be evident in Japan, South Korea, Taiwan and to a lesser extent Europe. This shift in productive locations will help offset the lost tonnage of iron ore demand from China. In addition, it is worth noting that China's focus on pollution is resulting in a higher demand for the best quality iron ore (lump and pellets). This works in favour of the large Australian miners, BHP and Rio Tinto.

The iron ore supply side remains relatively constrained but production from Brazil is gradually improving, as their COVID challenges improve. We forecast that major producer Vale will increase volumes by 30 million tonnes this year from their mines in Brazil. India remains a major uncertainty with rampant COVID infections potentially reducing last year's level of exports. Overall the market still appears tight this year but particularly in the first-half of 2021.

Despite the iron ore demand / supply backdrop continuing in a state of flux, in late April its price hit a new record high of close to US$200/t. This ultimately demonstrated that with the world progressing through its recovery phase, and with massive amounts of development occurring in property and infrastructure, the scales are tilted in this commodity's favour. 

As we look forward there remains uncertainty across market commentators as to where the iron ore price will move to. Our central view is that the spot price will weaken over the course of this year to average US$165/t in 2021 and US$120/t in 2022. This appears to be a negative forecast, but such a price would still result in material earnings upside for the mining sector relative to consensus expectations and would also support substantial capital return opportunities. On the basis of the current iron ore price the sector is generating a free-cashflow yield of almost 20%. On our base case of a declining price, the free cashflow yield ranges from 10-19% in FY21 and 10-13% in FY22.  Our top pick in the sector is Rio Tinto - we estimate Rio can return 35% of its market capitalization over the next three years and remain debt free. If it were to raise even a small amount of debt the potential size of a capital return increases materially. Both BHP and Rio Tinto are more diversified commodity exposures than Fortescue and with better quality iron ore, so this is our least preferred exposure in the sector.

Our core insight from the UBS-hosted event was that while the overall backdrop remains supportive for iron ore, there are a myriad of factors which need to be carefully navigated at an individual country and stock level. We believe this backdrop remains supportive for our active investment approach.

In our Investment Strategy Note we review the mammoth outperformance of stocks over the long run versus bonds and cash, including why we expect this to continue in the future despite calls by some of excess equity market valuations.

If a rising tide lifts all boats, then the Australian small and micro-cap market is experiencing what can only be described as the mother of all king tides.

There are several forces behind this monster tide, but monetary stimulus is the most significant.

While many market commentators have discussed the large amounts of additional liquidity provided by the US Federal Reserve, the Reserve Bank of Australia has actually been increasing the supply of M1 (the measure of cash or highly liquid assets in the economy) at faster rates.

Until the onset of COVID-19, Australian M1 supply had been growing at around 12% compound since 2000, compared to 8% in the US over the same time. 

Following the onset of the pandemic, M1 money supply in Australia has surged further. The RBA expanding M1 by around $320 billion or +29% year-on-year in its efforts to mitigate the economic impacts of the pandemic.

This liquidity surge has naturally resulted in a further cheapening of cash rates and falling bond yields.

The king tide is also being partly driven by the rise of the retail investor and passive investing.

Recently we've seen the incredible market impact retail investors on social networks such as Reddit have had in the US. This surge in retail investors trading on free or extremely cheap trading platforms is happening in Australia too. These are investors doing little or no fundamental analysis, but instead simply buying what's popular.

Likewise, ballooning passive funds simply select stocks in a given sector based on their size. There's no quality or valuation overlay.

The stock market beneficiaries

Expensive concept stocks are standout examples when considering the biggest beneficiaries of this market environment. Or put another way, they're examples of how to identify the so-called "investors" who are actually "swimming naked".

High-multiple businesses that are often labelled "disruptors" or "next-gen tech" are floating at all-time highs. Yet many make no money.

Below we have charted the number of ASX stocks with a market cap of between $50 million and $3 billion trading on an enteprise value-to-sales (EV/sales) multiple above 10-times. To provide context, we'd typically say an EV/sales multiple of more than 5-times is expensive. So, 10-times is truly significant.

You can see in the past year there's been a massive surge in the number of stocks on 10-times or higher.

If you break this down further and look at the recent growth of operating cash flow negative companies versus operating cash flow positive companies, you find further evidence of the types of businesses benefitting most from the metaphorical king tide.

Over the past 12 months, ASX small cap stocks with negative operating cash flow have materially outperformed those that actually have cash flow. This is illustrated below.

Why has this been occurring? 

The liquidity surge and low-rate environment have led to a zero cost of capital and markets today appear to be continuing to assume central banks will leave rates near zero for a long period of time, thus supporting the notion that cash tomorrow is worth more than cash today.

What could go wrong?

The answer is the re-emergence of the cost of capital.

A zero cost of capital is unsustainable and in our view, the re-emergence of the cost of capital is already underway.

While Central Banks are likely to continue to defend rates for as long as possible, they also appear to have been successful in generating inflation which is incompatible with ultra-low interest rates.

The re-emergence of the cost of capital will turn the tide. The investors swimming naked will be exposed. Those in their togs duly rewarded.

How to avoid being caught naked

When it comes to small and microcaps, cash today is king. Not aspirational future cash.

The proof is in the data.

When you look beyond the past year and back-test a portfolio of positive operating cash flow vs. negative operating cash flow companies, the result is stark.

Below we zoom out to provide you with a view across the past decade. The blue line (+872%) represents a bundle of all ASX small caps stock with positive operating cash flow. The orange line (+323%) represents the index and the grey line, a portfolio of stocks with negative operating cash flow.

We think long term investors in the small and microcap space should always assume an 8% cost of capital and apply a discounted cash flow valuation. As the tide subsides, discount rates are once again becoming relevant.

Small and micro cap companies with strong cash flow conversion rates offer a pillar of portfolio strength in reflationary environments and historically, have strongly outperformed.

As the crowd continues to ignore the warning signs, the opportunities are abundant for investors focused on finding great businesses with strong fundamentals.

Epicormic buds lie dormant, hiding underneath tree bark waiting for the right conditions to sprout. They serve a regenerative purpose in the overall forest system and flourish when conditions are at their most dire. Bushfires for example, trigger epicormic buds to sprout with extreme heat and the clearing of nearby vegetation. In other words, the emergence of new growth stems from the wreckage of the established.

Just as a botanist studies epicormic growth, I've been looking at buds and shoots in a different world. The questions remain the same. Which environments foster this latent growth? Where can I find the most regeneration?

I've spent a lot of time investigating these questions in the context of the current investment environment and I'll outline how I've positioned my fund.

Noise, distractions, smoke and epicormic buds

There's a lot of noise in financial markets. Think back only a few months ago during the Trump presidency. The headlines were volatile and anxiety inducing. We had it all, from a promise to clamp down on big pharma, to the US expulsion of Chinese companies accused of breaching data security, and the US withdrawal from the Paris climate accord. I've raised these headlines as examples because as much noise as they created at the time, they have all fizzled out like an old balloon. The world keeps revolving. But feel for Mr. Market, for at the time he was brought to his knees by the amount of anxiety this news had caused him. One can look back now and reassure him everything is ok, but at the time he was in no state.

Today the noise is all to do with interest rates and inflation. Endless predictions about the actions of central bankers and the interpretation of every word spoken at press conferences. The problem with short-termism and quick news is that everyone is focused on it. Everyone has an opinion. It's a crowded space. It is not where you can get a competitive edge as an investor. Instead, the edge comes from being able to strip away the noise and focus not on the smoke and fire, but seeking out the epicormic buds that are developing underneath. Don't be like Mr. Market.

The most common theme of today

Let me paraphrase today's rhetoric:

A huge wave of inflation is coming. Bond yields will rise in response, and so too will interest rates. This leads to a revaluation of assets as the time value of money increases the value of predictable cashflows as opposed to the uncertain.

This means companies with predictable cashflows come back into favour (value), as opposed to those with unpredictable future revenues (growth). It's a matter of perception - interest rates alter how analysts value companies, just like how the sea level changes the impression of a mountain's height.

The fact remains, a valuable company will remain valuable, just as a mountain remains a mountain. The effectiveness of either strategy, growth or value, is driven by the prevailing market conditions and whichever curries favour. Just like fashion trends, market conditions are becoming increasingly unpredictable.

Growth investors flourished last year as technology companies soared, but if your allocation had been solely to growth, you would be having a rough couple of months of late. The key to a resilient strategy is to remain adaptive. This means having a balanced portfolio that flexes with prevailing conditions without being overly extreme any which way.

And this is how I've positioned my portfolio.

Structuring a portfolio in today's environment

Given the inherent uncertainty and whimsical views of the market, there is opportunity to profit from both growth and value when markets flip from one school of thought to the other. With a dual structure, a portfolio remains balanced, there are no big bets and risk is tempered. What I'm seeking is a resilient portfolio that focuses on two types of buds.

Bud 1: Emerging companies selling new products and services

Bud 2: Existing companies experiencing temporary price dislocations but due for a resurgence

This structure captures the rise of both growth and value whichever the direction of sentiment. A 50/50 split at the start, which is then flexed when the opportunities prevail.

When I look for the Bud 1's, I'm looking for emerging companies that offer a compelling new product or service. They aren't startups, their product should be new, yet proven with growing demand. The customer base absorbs the new product like a fresh paper towel to a drop of water. It solves a problem the world has struggled with previously and craves for.

When analysing the Bud 2's, the lens is different - I'm looking for a resurgence or reinvention of an established business. Sentiment surrounding them may be negative and they may be facing a challenging macro environment. I'm looking for headlines that make Mr. Market nauseous. The bigger his overreaction, the better the opportunity.

Growth - the first mover advantage

Delving further into the first type of buds - emerging companies selling new products and services. This is all about capturing long-term possibilities and investing in growth opportunities.

Given today's market conditions, it's important to de-risk growth investing given the uncertainty with inflation and interest rates. I mentioned one of the strategies is to stick with proven new products that are already experiencing growing customer demand. Equally important is to find companies facing few competitors. If they're selling a new product or service, they should be one of the first movers solving a big problem for the world. Again it's all about de-risking the potential for a margin squeeze if inflation picks up. The safest companies in inflationary environments are those that command monopolistic pricing power.

Some readers may wonder: why not just avoid growth investing altogether? The weakness of this strategy is it assumes you'll be 100% right about the timing of when interest rates will rise. The all-terrain portfolio seeks to capture gains from any possible direction the market takes, including the next generation of world-changing companies. Sea levels fluctuate with the tide, but mountains will still be mountains.

Value - opportunities lie where there is greatest anxiety

Equally important is the search for the second type of buds - existing companies experiencing temporary price dislocations but due for a resurgence. These are the established businesses that haven't fully recovered from the pandemic - and there's plenty of them globally. In Australia we've recovered quickly but if you look across Europe, US and Asia, industries such as entertainment, hospitality, drinks, logistics and leisure will explode when their lockdowns abate.

Mr Market ruminates on uncertainty and often winds himself up in knots. Look for areas of greatest anxiety and that's where you'll find the greatest value. Value investing is about picking up immediate mispricings and targeting shorter term profits. But be prepared when stocks reach full value, you'll need to offload and recycle the strategy when growth plateaus to normalised rates.

Balancing the risk and reward

How the portfolio gels together is equally important as each individual investment. I spend the same amount of time thinking about the correlations between each investment to ensure the all-terrain portfolio spreads volatility. Look far away to Europe and Asia which are on a different recovery trajectory to the US and Australia. As specialists in founder-led companies, I also find European and Asian founders more prudently focused on generating profits rather than pumping revenue metrics, which again tempers the risk.

After any devastation, there will always be new growth. As the world recovers from this one-in-a-century event, pay attention to both the emerging new buds and the recovery of the existing trees. There are two types of gains to be made so make sure your all-terrain portfolio places you well for both.

Happy compounding.  

About me

Lawrence Lam is the Managing Director & Founder of Lumenary, a fund that invests in the best founder-led companies in the world. We scour the world looking for unique, overlooked companies in markets and industries on the edge of greatness.

Disclaimer

The material in this article is general information only and does not consider your individual investment objectives. All stocks mentioned have been used for illustrative purposes only and do not represent any buy or sell recommendations.

Ownership of this publication belongs to Lumenary Investment Management. Use of this material is permitted on the condition we are acknowledged as the author.