Thursday, May 13, 2010

Working in a Coal Mine

A recent media article hyped resource stocks, just a day before the Australian government slapped a big new tax on mining. Chalk it up as another reason not to stake your investment strategy on a single sector.

The illustration in The Australian Financial Review1 showed a miner's pickaxe breaking the dirt, showering sparks and diamonds. The accompanying text proclaimed that investors couldn't afford to ignore mining stocks.

Citing the extraordinary demand from China for raw materials, the newspaper said its own analysis showed the 100 best performing materials shares over the past five years had posted a median annual gain of 33 per cent.

The upshot, said the paper, was that investors needed to improve their knowledge of mining stocks to sort the speculative commodity plays in the equity market from the tried and trusted resource houses.

This all sounded very sensible…at least until the federal government the very next day unveiled a major tax reform package that had as its centrepiece a 40 per cent tax on the profits of mining companies.

Shares in global miners BHP Billiton and Rio Tinto lost 5.5 per cent and 7.5 per cent of their market value respectively over a couple of days. One broker estimated the tax, which takes effect in 2012, could reduce the companies' earnings by 17 and 21 per cent respectively in the first year.2

Of course, such companies as BHP and Rio are influenced by more than a single government's tax regime. Their market performance also came at a time of mounting concerns over Europe's debt crisis and its impact on global growth, a major determinant of commodity prices.

But this episode is yet another demonstration of why people should not seek to build their investment
strategies around a single idea or industry sector. There may well be a "commodity super cycle" underway, as some economists say, but investing this way introduces sector-specific and stock-specific risks that can be diversified away.

Dimensional breaks down equity portfolios not into mining stocks and banking stocks and healthcare stocks, but into broad asset class categories where the risk is related to an expected return.

This means a properly diversified portfolio will include large stocks and small stocks, growth and value stocks, domestic and international stocks and emerging market stocks. The exact mix will be determined by the needs and risk appetites of the individual investor.

It should be said that some of these portfolios may well include BHP and RIO, particularly if the investor chooses a dollop of large cap stocks. But the important point is that the portfolio is not built around a view about the mining industry or its prospects.

Ultimately, successful investing is not only about successfully capturing risks that offer an expected return, but reducing risks that do not. That means limiting one's exposure to random forces and not falling into the temptation of basing an investment strategy on an economic forecast.

Otherwise, it is like working in a coal mine—dark, dirty and dangerous.

1'Your Guide to Mining Stocks', The Australian Financial Review, May 1-2, 2010
2'Rudd Tells Australian Miners He'll Pursue Tax Plan', Bloomberg News, May 5, 2010