Good morning. There is good reason to expect a quiet week ahead. The recession scare has turned out to be just a scare. The earnings season is winding down and the economic data calendar is spare until Jay Powell speaks on Friday. In short, prepare for turbulence. Email us from wherever you are on holiday: robert.armstrong@ft.com and aiden.reiter@ft.com.
What makes a great stock?
Hendrik Bessembinder is well known for demonstrating that stock market returns are the product of a few stocks that do very very well and a whole lot of stocks that don’t do very well at all (see here and here). Recently he published a paper in which he discussed which stocks have produced the highest compound returns over the long term. The companies on the list are, as you might expect, defined not just by high annual returns but by having been around for a long time (Robin Wigglesworth has a nice take on the paper here and he came on the podcast to discuss it).
The best-returning stock on the list? Altria, formerly Philip Morris, which has a return of 265 million per cent since 1925. This makes sense: a wildly addictive chemical and excellent branding are a formula for sustained high profit.
The success of the second company on the list is harder to understand, Vulcan Materials has returned 39 million per cent over the last century or so, or about 14 per cent a year for 98 years. It has achieved this astonishing record in the business of, to simplify only slightly, making big rocks into little rocks. It quarries and sells aggregates — crushed stone, gravel, sand — to construction sites (it also has a sideline in concrete and asphalt).
Vulcan (known before 1956 by the less mythopoetic name of Birmingham Slag) has been a great stock for a long time, but also recently. It has outperformed the S&P 500 by a bit over the past 30 years and by a lot over the past 10.
Superficially, the big-rocks-to-small-rocks business lacks all the characteristics that Unhedged thinks of as producing great returns. It requires owning a lot of hard assets — quarries and heavy equipment. It does not have huge economies of scale; digging up, crushing, cleaning, and delivering the millionth tonne of stone is cheaper than the first tonne, but it’s still costly. There is no intellectual property to speak of, and no network effects. The product is a commodity, and not even a scarce one. In sum, it is the very opposite of the tech stocks that are the modern model of how wealth compounding is supposed to work.
But the aggregate industry does have two interlocking characteristics that are conducive to sustained profitability: high barriers to entry, and local rather than global competitive dynamics.
Mike Dudas of Vertical Research makes the point that while stone is abundant, quarries are not:
The ability, in the United States, to acquire the land, go through the environmental assessment to build a quarry, get through the permitting, and three years later to start delivering to your customers — it’s hard. So to have well capitalised quarries that have a long reserve life that will be around for another 40 years, located in areas that are benefiting from strong demographic trends, that’s powerful
A well-located quarry faces limited competition simply because stone is heavy. It’s not worth it to ship it very far, so pricing is determined by local demand and competitive conditions. Contrast this, for example, to oil, which is valuable enough to ship over long distances, making almost all producers takers of a global price. Here is David Macgregor of Longbow Research:
Moving a rock product to a job site you have a shipping radius of 50-70 miles. Your competitive dynamics exist within that radius — it’s not a product like, say, cold rolled steel, where there is a national price
As a result of these two dynamics, Macgregor says, “this is a business where you almost never have a year where prices fall.” The positive structural attributes of the business were on display in the second quarter. Shipments of aggregate were down 5 per cent as the rainy spring slowed construction projects. But double-digit price increases meant that revenues were up 2 per cent, and gross margins were up 6 per cent.
“Commodification” is a bad word for most investors. But commodity companies, and heavy industrial companies more generally, are not doomed to returns that hover around their cost of capital. That is important to remember at a moment when investors’ obsession with technology has turned the stock market into an all-in bet on that sector.
Oil and the dollar
The emergence of the US as the largest supplier of oil and gas on the world market has been seen as a generally good thing. When the swing supplier is a stable country, that makes for a more predictable market for the most important of all commodities. But US production leadership has also changed the relationship between oil prices and the dollar, which could have unwelcome consequences for the global economy.
Up until the past few years, the correlation between oil prices and the dollar has been mostly negative:
This makes sense. Brent, the global benchmark, is priced in dollars. So as the cost of oil goes up, it takes more dollars to buy oil (that is, the dollar is weaker). At the same time, the dollar tends to fall when the trade deficit widens. When the US imports more, dollars flow out of the country in exchange for other currencies, and the dollar weakens. This was true for oil when the US was a major energy importer.
Now that the US is a net exporter of oil, the relationship between oil and the dollar has flipped. In the past few years, correlation between the dollar index and Brent futures has been positive:
This shift is part structural, part mechanical, and part coincidental. Structurally, demand for the dollar is net up as more economies purchase US oil and gas. Mechanically, the prevalence of US oil on the market has altered how Brent futures are calculated. Here is Ed Morse, former head of commodities strategy at Citi, now an adviser at energy and commodities firm Hartree:
At some point in the last couple of years, there was no longer enough North Sea crude to make settlement for Brent contracts. So US oil, typically priced by Midland oil contracts, [started to be] used for settlement in the North Sea. So US crude has become more central than Saudi crude and Russian crude, [and] in the benchmarks like Brent. Brent is still the same benchmark, but now it is settled through US crude.
Finally, happenstance. The recent rate hiking cycle was necessary, in part, because of energy price inflation, driven by Opec production cuts and sanctions on Russian oil. US oil supply exceeded projections, filling the gap in global demand. But at the same time, the US economy ran hotter than its counterparts, leading the Federal Reserve to raise interest rates higher than other central banks, increasing global demand for dollars.
While the impending rate-cutting cycle by the Federal Reserve and an end to the war in Ukraine could dampen the trend, the structural and mechanical factors should remain. From Hunter Kornfeind at Rapidan Energy Group:
The US will continue its role as a net energy exporter across both gas and oil. We still expect crude production to grow. It will continue to be a major supplier to Europe and will continue to serve as a bigger part of the Brent calculation.
This will have implications for the global economy. Back when more expensive oil tended to be accompanied by a weaker dollar, oil importing countries paid more (in dollars) for oil, but other dollar-priced imports became cheaper. Now countries such as Japan face a double hit, as more expensive oil and a higher dollar push growth down and inflation up. For countries with dollar-denominated debt as well — Kenya is an example — it’s a triple whammy. American energy dominance is not an unalloyed global blessing.
(Reiter)
One good read
How to make millions while your own hospitals go bankrupt.
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