Best in breed: Scott Phillips
It’s a tough business, so investors need to know how to pick a winner
Finding companies that represent the best in their industry can be a challenge. Clues can often be found from revenue growth. Or the increase in profits. Some hints can come from ratios like return on equity or invested capital. You might look for a track record of new product innovation, or a competitive advantage from a brand or product that cannot be replicated.
And then there’s resources.
Now, I don’t mean to look down on resources companies – goodness knows they’ve been responsible for more than one national case of the economic equivalent of John Howard’s “Lazarus with a triple bypass”. We escaped the worst of the GFC, for example, in part because our banks were responsible, but also in part because we had an almost unprecedented resources boom that kept Australians employed and the budget coffers full.
I have to say, though; as far as traditional investment metrics go, resources companies have little to recommend them. There is no product differentiation, no brand to speak of. They have precisely zero in the way of pricing power, and their results, year to year, are unpredictable and usually pretty volatile.
Their revenues fluctuate with the price of the commodity they sell. And with little in the way of variable costs able to be added or withdrawn, as a result their profits whipsaw at an even greater rate – in both directions – than their revenues. (Here’s the hypothetical maths: $100 in revenue and $60 in costs is a $40 profit. But $50 in revenue, for the same volume, and $50 in costs is a 100% fall in profit, even though revenue only halved.) And they can’t differentiate. They’re always using up the very asset they control, needing to find or buy new deposits just to stay in business over the long term.
In short, even the best operators have a tough job just to stay in business, let alone make money, over time. (If that reminds you of airlines, you’re right – the two have more in common than is initially apparent!)
But what if, despite the potential pitfalls, you want to invest in resources companies? Then I have two pieces of advice.
First, try to invest when the price of the commodity is close to the cost of production. It’s possible for the price to stay below the cost of getting it out of the ground for a time, but not forever. So while this strategy won’t put a perfect “floor” under your investment, it puts the odds as far in your favour as you can get with these sorts of companies.
Second, seek out quality. Look for the operators with the lowest cost of production, the cleanest balance sheet, the best track record of production and expansion, the lowest “time lost to injury” (as a moral view, but also as a proxy for production quality/care). In short, if you can’t control the wind and the waves, make sure you’re in the sturdiest vessel.
Scott Phillips is The Motley Fool’s chief investment officer. You can reach him on Twitter @TMFScottP and via email ScottTheFool@gmail.com. This article contains general investment advice only (under AFSL 400691).