If you win the lottery don't spend it all on more tickets
– David Wanis, June 2020
The quality of resource businesses is not determined by the foresight of government or the hard work by entrepreneurs or management. Both are required to unlock value, but the asset quality and superior economic returns owe more to geology than commercial skill. Australia is called the lucky country for good reason.
Arguably the single most important attribute of a mine or an oil well is the character of the deposit itself. Human skill in geology, engineering and financing are important but secondary to what is in the ground. A simple definition of quality may be the extraction cost (assuming average skill) relative to the industry cost curve for a given commodity. Commodities are the ultimate price = supply / demand market and industry cost curves tend to determine the clearing price for a given level of demand in the long run. If the quality of my deposit (think West Australian iron ore, or Saudi Arabian oil) means I can extract and deliver meaningfully cheaper than three-quarters of my competitors, and assuming that in the long run, the clearing price allows a close to cost of capital return for the highest cost competing producer, then my return on capital can sustain at well above my capital cost.
This is not just theory. We observe this in the market where proven low-cost resource producers can sustain returns on capital of over 20% thanks to the luck of the discovered geology.
The problem for investors is that luck is not scalable or repeatable. Ex-ante, exploration companies face extremely unfavourable odds of finding the unicorn deposit that will confer 20% plus returns on investment for years or even decades. Ex-post we can observe the small number of winners who have discovered and commercialised such assets, meaningfully reducing the odds of failure.
We believe that the market priced odds for commodity exploring small caps are unattractive. The noise in share prices they impart on the sector can mean that high quality, proven resource assets can be prejudiced or obscured.
Resource equity returns
Between 2003 and mid-2020, the S&P / ASX Small Resources index delivered total returns of 5.5% per annum, 1.4% per annum lower than the Small Ordinaries benchmark. Not only were they lower, returns delivered were riskier with an annualised volatility of almost 29% per annum (vs 18% for the benchmark) and a maximum drawdown of 82% (vs 61%).
Given this experience, we can understand why many investors decide to avoid small resource companies altogether.
We think that the companies in the large-cap S&P / ASX 200 Resources index are more representative of quality resource stocks as per our definition of these as proven, producing, low cost, high return on capital assets. This group has delivered returns of 9.3% per annum over the same period – significantly above small resources, as well as 1% per annum more than large industrials over the period. This was achieved with volatility of 21% (vs ASX 200 of 14%) and a maximum drawdown of 59% (vs 47%).
Somewhere in this gap of higher returns and lower risk between large and small-cap resources is the effect of reducing the exploration risk and increasing the number of quality businesses in a small-cap resource portfolio.
Reinvestment opportunities and risks
Reinvestment is one area where resource companies can be less attractive than industrials. Many high-quality deposits are very profitable but finite. They may generate a strong stream of cash flows for many years at a constant rate of production but reinvesting and compounding that cash flow within the business can be difficult. Like the lottery winner who spends his winnings buying more tickets, many resource company managements overestimate their ability to repeat their luck and mis-allocate shareholder funds learning this lesson. Instead of paying out the cash flow as dividends, they expose shareholders to bad exploration odds or pay away premiums to acquire other assets with no operating synergies.
For industrial companies, an idea can be more scalable than a deposit. Even if a similar amount of luck is required to find and commercialise a high quality (high return on investment) idea, the physical bounds of geology do not apply. That is not to say industrial management teams do not misallocate capital, but many have a better set of choices and the good ones know how to focus on turning the compounding flywheel.