There are many convincing arguments to be made for both embracing and shunning the junior sector entirely at this point in the cycle. At risk of flip-flopping, my take is more nuanced, but "throwing the baby out with the bathwater” at this stage is an unwise move.
I have said since Q4 2013 that I believe we have finally hit bottom. This does not mean that we have turned the corner and the commodity super cycle will pick up where it left off. That said, I think it’s worth examining what were the forces that brought us to this point and determining how to navigate in the current environment.
A Band Aid on an Amputation
Recent attempts by global central banks to “fix” the global economy have not achieved their goals and one wonders if they ever will. Flooding the global economy with excess liquidity thanks in part to a low (or zero) interest rate environment has only masked or “papered over” the challenges we face. If this weren’t true, then why does the US 10-Year bond yield 2.50% as I write? This is the result after unprecedented Federal Reserve balance sheet expansion to $4 trillion in assets.
The results are strikingly similar in Japan and the Euro Zone. The bottom line is that attempting to fix the global economy (some would say “prop up”) has led to an era of abundance or excess. Depending upon your point of view, this can be a good or a bad thing. I’m going to argue that the type of abundance we see now is bad.
The Culprits and their Results
There are three major culprits which have combined to produce two primary excesses in the global economy. These are:
· Low interest rates
· Ubiquitous technology
Though these factors have undoubtedly had some positive consequences (poverty reduction, productivity increases), after 2008 these forces have combined to produce two primary excesses. These excesses are in large part responsible for the downdraft in commodities (and by extension the junior sector) in recent years. It is these excesses we must deal with in order to get the global economy on a sustainable footing and presumably commence with a new commodity and credit cycle. They are:
· Excess Labor
· Excess Capital/Cheap Money
Mouths to Feed
The burgeoning middle class in Asia and the increased consumption that implies is a central investing thesis of ours. We still strongly believe that this phenomenon will continue in the coming decades. That said, an individual joining the middle class can only do so while earning a wage to support newfound consumption. With 600 million starting to live a middle class lifestyle in China with forecasts of another 200 million set to join in the next decade, it is incumbent upon the political class in that country to provide jobs for those looking for work.
Add to this total an approximate additional 650 million citizens in countries including Indonesia, Mexico, and Pakistan and 100 million who are not in the labor force in the United States and you can begin to see why real wages have stagnated in the West in recent years. A glut of excess labor has given employers power to dictate wages in pursuit of maximizing profit for stakeholders.
Below is a graphical representation of what excess labor means for lost output (and a lower quality of life) in the United States:
Adding to this convergence between East and West is education – specifically access to education.
Dan Alpert has written an excellent book titled “The Age of Oversupply” which echoes many of the sentiments in this Note. Regarding education, he states:
“In China alone, the number of students graduating annually from college has risen eightfold in the past 15 years…”
That’s a yearly increase of 830,000 to 6.8 million per year in 2012. The numbers are significant in other emerging market economies as well. So we in the West are facing an increasingly educated adversary with a dramatically lower cost of living. This should send shudders down the spine of both blue and white collar workers everywhere.
Capacity is No Problem
So as labor has become plentiful, global central banks have attempted to resuscitate the global economy through myriad programs including QE, Operation Twist, ZIRP, Three Arrows, etc. Here are the results:
Trillions of dollars in excess liquidity all looking for above average returns. As these programs continue (though QE is believed to be “ending”), you can see the long term trend in US interest rates:
All the pump priming by global central banks and all we can muster in the US is a 2.50% yield on the 10 year government bond. Given this backdrop, is the global economy really on the mend?
It is for this reason (the confluence of low rates, globalization, and technology access) that we continue to believe that deflationary forces are of primary concern. In this environment, finding ways to increase productivity amidst excess will be key to your investment strategy. Doing more with less would appear to be the “new normal” such that it exists.
A Case Study in Deflationary Effects
A case study in these deflationary effects can be seen with two companies not at all involved in the commodity or critical metals world at all: Blockbuster and Netflix.
In 2004, Blockbuster had a market cap of $5 billion, 5,000+ outlets, and 60,000 employees. Six short years later, the company was bankrupt, relegated to the graveyard of corporate history. Netflix (NFLX) , the primary culprit for Blockbuster’s demise, operates in 20+ countries, has a $19 billion market cap, and does all of this with only 2,000 employees. This is a profoundly deflationary dynamic and a perfect example of the confluence of excess labor and technology.
The bottom line here is that Blockbuster was “netflixed”. This leads me into how to approach the junior sector today and in particular the critical metals sector. A focus on disruption or those companies with unfair competitive advantages is a vital method I use to gauge the potential for the success or failure of an enterprise. Some examples of exciting disruptive opportunities across the economic spectrum:
As the excess of labor and capital/cheap money are worked off in the coming years, it is these types of companies that I am betting will be the new engines of economic growth going forward.
You may be asking, “What does this mean for critical metals?” I think the excesses are ultimately positives, as they will force resource companies across all market capitalizations to become more efficient, focused enterprises. Perhaps even more importantly, we can now see more clearly which metals are truly critical. It is vital to understand that each critical metal has its own supply and demand dynamic and lumping all critical metals underneath the same umbrella is a mistake in an environment where many of these companies are unloved and left for dead. Disruption in mining will be key as excesses are worked off.
Disruptive Examples in Critical Metals
There are likely numerous examples, but here are a few I am focused on and why.
· Scandium – No scandium is currently mined anywhere in the world. The supply (15 tonnes per year) comes primarily from stockpiles and tailings. Scandium’s unique properties with weldability make it an ideal alloy with aluminum for jets and its ability to withstand heat make it an optimal choice for solid oxide fuel cells. The solid oxide fuel cell market can accelerate subject to a reliable supply of scandium. (In the interest of full disclosure I am long EMC Metals (EMMCF) , a scandium exploration and development play in Australia).
· Graphene and Materials Science – I really do believe that materials science is the “next frontier” and an understanding of some of the transformative technologies and their applications can help position you amongst the critical metals. Graphene has received much of the hype of late and though it isn’t economic to produce in mass commercial quantities, I think this will change going forward, with profound implications for several metals or minerals. It is more of a question of “when” as opposed to “if.”
· Tin and Cobalt – Tin and cobalt are two metals I have written on extensively. What makes them unique is the source of their disruption – government interference. The Indonesian government’s new laws banning raw ore exports has lit a fire underneath tin and nickel specifically. Cobalt is also subject to disruption based on the fact that it is mined in reasonably unsavory jurisdictions and it is also typically a byproduct. Given their need, in technological applications, an understanding of the source (and potential resolution) of any disruption is important.
· Aurora Control Technologies ($AACTF) and Argex Titanium (ARGEF) are two prime examples of companies I think have the capability to disrupt their respective industries. This is solar panel manufacturing in the case of Aurora Control and the titanium dioxide market in the case of Argex. I will be writing more on both companies shortly. As an aside, I have written a complete report on Argex you can access here. I am long Argex.
The Four Keys to Critical Metals and Takeaways
At this stage of the cycle, it should be clear that I think that ignoring critical metals altogether is a mistake. The four primary keys to success in an era of so many excesses are disruption or unfairness in a business model, inefficient markets (thanks to government meddling), a focus on the value chain in an industry, and finally an off take or strategic agreement which offers the ability to significantly de-risk an opportunity.
Despite the troubling economic headlines, I think it is important to remember the trend is your friend and while China is indeed slowing its growth rate, consumption has come a long way and still has a long way to go before catching up to Western levels.
The data above is backwards looking, but offers a powerful vision for future potential across the critical metals markets. I am currently more focused on growth in consumption rather than GDP growth and more focused on Services PMI data rather than Manufacturing PMI data in the emerging markets. A growing services sector is the “type” of growth I think you want to see as a country like China slowly alters its growth paradigm from exports and fixed asset investment to one more focused on internal consumption.
All critical metals are not created equal and it is those disruptors in the space that are poised to lead us forward.
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