I am a great fan of Star Wars and very much admire the way the Jedi say farewell to each other. I have been thinking recently about their now-famous words, "May the force be with you", and find that they summarise my views on the stock market.
Investors need to develop a thesis or theme for their investment strategy. For several years now, I have believed that we are in a commodity super-cycle that's likely to last for another decade. I wrote about this for Investors Chronicle in and recommended an investment in BHP Billiton at 956p and an investment in Junior Oils Trust at 160p to take advantage of the trend in metals and oil prices. The same thinking guided me when I helped to found Galahad Gold, which generated an internal rate of return of 66 per cent a year over a period of four years. I am still bullish about metals in general and BHP in particular, but my business partner, Ian Watson, and I now feel that the low-hanging fruit has been picked and we are moving into agriculture, which we think offers more upside potential.
As part of the super-cycle, we believe that food prices are likely to rise substantially. There are many reasons for this:
1. The growing world population.
2. Increasing affluence in China and south east Asia with greater demand for high-protein food. It takes eight kilos of cereals to produce one kilo of beef.
3. The invasion of grain-bearing land by biofuel producers who in the US are heavily subsidised. In 2008, the US biofuel industry will consume one-third of the country's corn crop for the 2008-09 season - up from 22 per cent last year.
4.The US Department of Agriculture predicts that corn stocks will fall to a 33-year low and that, by the end of the 2007-08 crop year, wheat stocks will be at 60-year lows.
5.Climate change with the greater incidence of droughts and floods makes crop production less reliable. A horrendous example is the recent cyclone and floods in Burma spoiling the rice crop and causing devastation and many deaths. Also remember that North America has experienced good weather for the last 18 consecutive years. You have to go back 800 years to find such a favourable lengthy period. This year, American farmers are behind with their corn crop planting due to poor weather conditions. If bad weather persists throughout 2008, food prices will rise even more dramatically.
OIL AND FOOD
As the super-cycle continues, the price of oil is also likely to increase to a much higher level. There will be setbacks, of course, but Goldman Sachs forecasts oil at $150-$200 a barrel within the next two years. The demand from China and India continues to be exceptional and now even in the Middle East more oil is being consumed. America is thought to be in a mild recession but it is no longer pivotal. Any nasty surprises are likely to be on the supply side, such as the Nigerian terrorist attacks and the Grangemouth strike. Also, a very large proportion of the world's oil is dependent on the Middle East, which can best be described as a tinderbox. Another important factor is that there is not much elasticity in supply. Peak oil production seems to have been reached as major producers are finding it difficult to lift production and many of them, like the UK with the North Sea, are in decline.
If you accept my arguments about oil and food prices, it follows naturally that consumers will have much less money to spend. The increased cost of necessities like food and fuel for transport and heating will eat into discretionary spending money, as will increased taxes and higher rates of interest for mortgages. To make matters worse, due to the credit crunch consumers are unlikely to receive much help from the banks and, as their houses fall in value, the feel-good factor will disappear (if it hasn't already).
PRODUCERS, NOT CONSUMERS
With these thoughts in mind, let's look again at the Jedi hope that the force will be with you. In market terms, the force dictates the trend and, because fluctuations can be so violent, it is vitally important not to be on the dark side of it. For example, it is obviously far better to be invested in an oil producer or an oil service company, both of which benefit from increased oil prices, than in an airline that has rising fuel costs and also suffers as its customers have less money to spend on their holidays.
Similarly, with food prices going up, it is clearly better to invest in a food producer or an agricultural services company such as Potash Corp, as opposed to a restaurant or a company such as Starbucks, which has recently announced disappointing figures due to "US customers responding to rising food and gas prices by making fewer latte runs". The force is with Potash Corp. It is not with Starbucks.
The next step is to try to identify relatively good value within the sectors that are helped by the force, while avoiding companies that are on the dark side of it. Take oil, for instance. As often happens with fast-rising commodities, analysts base their estimates of net asset value and future earnings on very conservative assumptions far below spot prices. In a super-cycle, this results in them always being behind the curve. For investors who believe in the super-cycle, this means that well-chosen oil shares offer much better value than analysts' estimates suggest.
