The ratio between the value the market ascribes to a company (the market price multiplied by total shares issued) and the historic cost of a company’s assets (book value) is known as the price to book ratio. This ratio can provide a crude estimate of the premium the market is placing on a company or industry. Changes to this ratio over time can provide investors with a useful perspective, particularly for capital intensive industries that produce commoditised products. For example, in 2008 resource companies (metal, mining and energy) were valued at 5 times the depreciated historic cost of their assets (net of debt). Today they are valued at 1.2 times their book value.

When business conditions are favourable, valuations often become unfavourable

Resource companies certainly weren’t the flavour of the month at the turn of the century after a decade-long decline in real prices of many commodities. However, in the years that followed, markets began to anticipate an extraordinary increase in demand for commodities from fast growing emerging markets.

Prices started to rise for a wide range of commodities and with this, profitability expectations grew for companies in the resource sector (whether they owned the resources, looked for them or serviced companies that did this). There was a dramatic increase in the valuations of many of these companies. By June 2008, the aggregate valuation of resource companies had risen to about 5 times their book value.

Graph - Resources price-book ratio

Source: MSCI

Favourable business conditions tend to bring competition and investment in new capacity

An enormous amount of investment in commodity exploration and development was planned as the outlook for commodities continued to improve. Iron ore (steel’s primary input) provides an interesting example. China’s steel production quintupled through the decade and, at their peak, prices for iron ore had risen by an even greater magnitude! However, these prices were unlikely to be sustainable, as iron ore resources are plentiful and known reserves will last for many decades. What was needed was the infrastructure to access this ore, including mines, railways and ports. High prices provided the incentive to build this infrastructure.

In Australia alone, investments in resource projects of all types rose from $12bn per year in the 1990s to almost $100bn in both 2012 and 2013. Prices for many commodities began to fall as concerns about inadequate supply started to ease and were then replaced with concerns about excess supply. By the time oil prices started falling in late 2014, few commodities prices had been left unscathed. As shown in the chart above, the valuations of resources companies followed suit.

When the outlook is least favourable one often finds compelling investment opportunities

History suggests that the downturn for many commodities could continue for a protracted period. Huge amounts of capacity have been added for a wide variety of commodities and some projects that were planned in the good times are still being completed. With such an unfavourable outlook, resources companies certainly have far fewer friends today than in 2011. However, it is situations like this that can create opportunities to acquire stakes in companies with high quality assets at reasonable prices. (For resources companies, when we refer to quality we are referring to low cost, long life assets.)

As one example, a broad section of energy companies will find it uneconomic to make the investments required to replace declining production assets at today’s oil and gas prices. Baker Hughes publishes a weekly count of active oil and gas drilling rigs. The number of active drilling rigs has declined 40% in the last year. In time, something will have to give.

A concentration of such opportunities makes our portfolio look very different to the market

Our investment process is based on the bottom-up appraisal of individual companies. Nevertheless, as contrarian investors, it should not be surprising that the aggregate industry exposures across our portfolio are different to the market. This is reflected in our changing exposure to resource companies over time. In June 2008, we had a 23% exposure to resource companies compared to the benchmark weighting of 36%. Today our exposure is 34% compared to 15% for the benchmark. The majority of our resource investments are in energy and gold companies.


Tim Hillier is an Analyst at Allan Gray. Tim holds a Bachelor of Business Science and a Post Graduate Diploma in Accounting (University of Cape Town) and is a Chartered Financial Analyst and Chartered Accountant.