Fine to get on board, but know when to leave train

As investors what have we learnt from the decade-long mining boom and its bust? I know this sidesteps the debate of whether the bonanza is actually over, but those who get bogged down in technical conversations will miss the fact the financial world moves relentlessly forward. So we should not be negligent, and conduct a post mortem to store a handful of lessons in the memory bank.

The first lesson is that like most booms, this mining one was fleeting and not permanent. In the nascent days from 2000 to 2004 there were many non-believers, most relics of the 1990s who warned that commodities are highly volatile and green investors should tread wearily. By 2007, the pendulum had swung and virtually everyone was convinced it was different this time; the catchcry became "stronger for longer". Who could disagree given the All Materials index on the Australian Securities Exchange rose 461 per cent in just eight years?

This view of a new era was cemented in 2009 when the Chinese government dropped $600 billion into its economy, firing the greatest fixed asset boom in living history. Three years on we have been reminded commodities are not special and prices are determined by supply and demand. As supply rose and demand eased, miners' share prices collapsed. It was confirmation mining stocks should trade on low price earnings multiples when earnings are historically high.

The second great lesson to take away was the remarkably concentrated nature of this boom. Effectively, there has been only one incremental buyer of Australia's commodities for the best part of a decade, that being China. This unfavourable situation was compounded by the fact that China is a centralised economy and all economic decisions turn on those of a few people sitting in Beijing. So what, you say. Well any company that has only one customer is considered highly risky and trades on low earnings multiple. The same can be said of the whole Australian mining sector.

If the mining industry rebounds soon because of a revival of the Chinese economy or in 15 years time inspired by the emergence of India, the next sleeping giant, it should be remembered that mining stocks should always trade at very low earnings multiples in the middle of boom. This does not mean you should ignore it like the naysayers, but embrace it with a sober eye on the future.

Investors should also be cautious not to lump all commodities in one basket. The bulk and base metal companies that depend heavily on global economic growth and, in particular China, don't dance to the same drumbeat as oil, gas and precious metals. This divergence should continue.

From a company point of view we can also note salient investment lessons. Any boom will attract entrepreneurs. It will also attract enormous amounts of capital, both equity and debt. The combination can create enormous wealth in a remarkably short time. It was the case in the 1980s when Australia's banking system was deregulated and money became freely available. Like bees to a honey pot the players of the day - Bond, Skase, Spalvins and Elliott - were buzzing around to get their fill.

This time around we have another list of players who have come from virtually nowhere to be Australia's wealthiest people, among them Forrest, Palmer, Tinkler and Rinehart. There is no suggestion this group has carried out the same misdemeanours of those in the '80s. However, entrepreneurs are particular types of humans who are prepared to take enormous risk under virtually any circumstances. This can create enormous amounts of wealth but it can also destroy value at an alarming rate.

Andrew Forrest bounced back from the disappointment of Anaconda Nickel in rapid time to form Fortescue Metals. His herculean efforts to become a third force in Australian iron ore in just several years is to be admired. However, Forrest is an entrepreneur and a risk-taker. Despite his enormous personal wealth, he decided to roll the dice again and expand company operations threefold, using debt to do so. Most entrepreneurs in listed companies fall in love with debt because it allows them to grow without diluting their own shareholdings. This is what Forrest did. Strapping on billions of debt put the whole company at risk. It would seem Forrest and his team never considered the consequences of iron ore prices heading back to historical averages that would seem unfathomable.

The other major example of an entrepreneur's addiction to debt is Nathan Tinkler. While this had limited impact on other shareholders, the comical events at Whitehaven Coal in recent weeks has started to have an impact. Tinkler became a billionaire in world record time by using debt to leverage up his equity position. Even when he had made it to the big time and cashed in on the boom, he had to roll the dice again. Now his financial position is vague to say the least and shareholders in Whitehaven are keen to see his stake of just over 20 per cent offloaded so the stock can trade at levels closer to analysts' valuations.

The lesson from these examples is to always be careful of the motives of these entrepreneurs. If they make you money on the sharemarket, it may be best to depart the train and let others go for the next leg of the ride. No doubt when the next boom arrives, whether it be in mining, technology, housing or finance, there will be a new batch of money-makers attracted to the honey pot who will make you money but risk it all because they have a fatal addiction.

The story Fine to get on board, but know when to leave train first appeared on The Sydney Morning Herald.

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