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The Chicken Cycle
The Commodity Cycle with Pilgrim's Pride, Leucadia National and Fortescue Metals
“As Yogi Berra says, “It’s tough to make predictions, especially about the future.”
Clichés about the business cycle abound. Epitaphs like “the four most dangerous words in investing are ‘this time is different’” or “history doesn’t repeat, but it rhymes” are almost painful to type. Their triteness comes less from their content and more from their usage: As a stand-in for actual analysis or insight. The capital cycle, the boom and bust of commodities or high-growth companies, is an imprint on the market yet vanishingly few seem capable of profiting from it. This is partially a result of mistaking a mechanism for a natural law. Reversion to the mean of equity returns describes the outcome of a process, not some emergent phenomena. Returns don’t fall simply because they have strayed too far from their statistical mean, instead profitability has attracted new entrants to a market driving down margins and with them, returns on equity.
The Chicken Cycle
Across industries, the commodity cycle is well known. Constrained supply from underinvestment in capacity catch producers wrong-footed into an exogenous surge in demand. Higher prices and profits lead managers to increase supply, all coming online at roughly the same time and driving out the very profits they are chasing. From a 2014 Value Investor’s Club post about Pilgrim’s Pride1:
The chicken cycle is one of the investment world’s great short themes. The opportunity to short the chicken cycle reappears every 2-3 years as the chicken industry follows a repeating supply-side driven cycle. While pundits and the sell-side wax enthusiastic about growing chicken demand, high pork and beef prices relative to chicken, rising exports, falling corn prices, operating efficiencies, supply constraints, animal diseases, a changing industry structure, etc., this is all “white noise”. The chicken cycle is about one thing and one thing only: how much chicken is produced in the United States. Keep your eye on the ball and you will have a lucrative trade on your hands…Today, chicken producers are extremely profitable and we see clear signals that a large supply response is on its way that should lead to a massive oversupply of chicken by 2016 if not sooner. It’s time to be short.
Why do companies engage in this? Aside from general myopathy and empire building, market forces all but demand it. From Capital Returns:
Game theory can also explain overinvestment within an industry. Managers in a business with high current profitability may face a problem akin to the prisoner’s dilemma. Take a situation where future demand growth can profitably accommodate expansion by a single player, but no more. If several players simultaneously expand their operations, their aggregate profits will decline at some future date. Under such circumstances, it’s collectively rational for the incumbents to prevent any expansion – since gains only accrue to one of their number. If the industry is competitive or has low barriers to entry, there is an incentive for one player to break ranks and enjoy the fruits of expansion.
When it comes to commodities there simply seems to be no way to break the cycle.
We find ourselves in a period of high commodity prices that appear, if not structural, at a minimum caused by intractable problems with solutions hindered by competing initiatives. While both are beyond the scope of this publication, the understanding of this cycle through the lens of the past can be useful, specifically through the early-aughts commodity cycle which was driven by growth in China. Like all cycles, cause and effect look neatly ordered in hindsight but were far from consensus at the time.
The World For Sale: Money, Power, and the Traders Who Barter the Earth's Resources by Javier Blas and Jack Farchy provides useful framing the conditions that lead to a “Commodity Supercycle”
Supercycles are demand led, and last longer. They tend to coincide with periods of rapid industrialisation and urbanisation in the global economy. The first modern commodity supercycle, for example, was triggered by the industrial revolution in the nineteenth century in Europe and America; the second, by the global rearmament before the Second World War; the third, by the economic boom of the Pax Americana
There is a particular stage of development that lends itself to commodity demand.
As long as a country remains relatively poor, with annual per capita income below about $4,000, people spend most of their income on the basics they need to survive: food, clothes and housing…The same is true for a very rich country. Once a nation’s income rises above roughly $18,000–$20,000 per capita, households spend any extra income on services that require relatively small amounts of commodities: better education and health, recreation and entertainment. Governments of such wealthy countries have usually already built the bulk of the public infrastructure they need…In between the two extremes, there’s a sweet spot for commodities demand. After per capita income rises above $4,000, countries typically industrialise and urbanise, creating a strong, and sometimes disproportionate, relationship between further economic growth and extra commodity demand.
Demand however, as the good Mr. Berra pointed out, is very difficult to predict. China exceeded all expectations of demand. Again from The World for Sale:
The transformation unleashed three decades of spectacular growth in China, with the economy expanding by an average of 10% each year between 1980 and 2010. In the biggest economic metamorphosis since the industrial revolution in Europe and America in the nineteenth century, China became the world’s factory, producing everything from household appliances to iPhones. By 2008, China was exporting more in a single day than it had done in the entirety of 1978
In 1990, for example, China consumed the same amount of copper as Italy did; today, every other tonne of copper on earth goes to a Chinese factory.
Leucadia National & Fortescue Mining
The quotations from this section are all from Leucadia National’s shareholder letters years 2006-2012, emphasis mine.
With any investment there is the message and the medium, in other words, the underlying bet and the way you go about expressing that bet. Perhaps no transaction reflects intelligent cyclical investing better than Leucadia National’s investment in Fortescue Mining.
Ian Cumming and Joseph Steinberg were former Harvard Business School classmates when they teamed up professionally to restructure financial holding company Talcott National Corporation and establish the foundation of what would become Leucadia National. Between 1978 and 2012 Leucadia’s share price would compound annually at 25.7%, trouncing the S&P 500’s total return of 11.2% per annum.
We tend to be buyers of assets and companies that are troubled or out of favor and as a result are selling substantially below the values which we believe are there. From time-to-time, we sell parts of these operations when prices available in the market reach what we believe to be advantageous levels. While we are not perfect in executing this strategy, we are proud of our long-term track record. We are not income statement driven and do not run your company with an undue emphasis on either quarterly or annual earnings. We believe we are conservative in our accounting practices and policies and that our balance sheet is conservatively stated. -What We Do from Leucadia National’s Annual Shareholder Letters
Cumming and Steinberg had noticed China’s rise as an economic force and with it, the country’s insatiable demand for commodities. Iron ore, like many commodities had spent the majority of the century in perpetual backwardation (lower forward prices). The resulting constrained investment in mining was rapidly coming to a head with a tsunami of Chinese demand.
For decades iron ore prices in real terms followed a long-term downward trend (see below). This resulted in companies and investors not spending capital to develop new reserves and mining capabilities. But since 2003, driven by China’s surging iron ore appetite, prices have been increasing and producers have been unable to keep up with this demand. Global demand for seaborne iron ore in 2007 was 788 million tonnes, of which China represented 48% of the total, compared with 16% in 2000 and 11% ten years ago. Iron ore prices have reacted to this supply deficit: in 2003 the contract benchmark price increased by 9%, followed by 18.6% in 2004, 71.5% in 2005, 19% in 2006, and 9.5% in 2007. Naturally, increased demand and stagnant supply led to shortages, resulting in increased prices. Having failed to anticipate China’s surging demand the iron ore producers have now been frantically investing to build supply.
Andrew Forrest, a brash former stockbroker from the Philbara region of Australia had taken control of Allied Mining and Processing and renamed it Fortescue Metals Group in 2003. Fortescue had essentially nothing to show for its existence when Leucadia invested except “35,500 square kilometers of mining tenements. Tenement is Australian speak for mineral lease.”
China is a relatively short distance from the Pilbara in Western Australia, where Fortescue and others mine their iron ore. China is hungry for iron ore. China has a population of 1.3 billion, many eager to abandon subsistence living and desiring to emulate the well fed, well clothed and well educated life of Australians, North Americans and Europeans. Creating an urban industrial country of this size takes a huge amount of iron, steel, concrete and money and it will take a very long time. Fortescue should have a bright future.
The genius of Leucadia’s investment was both its structure and its target. They were funding a crazy Australian wildcatter and intended to participate in proportion to the risk. The mines Fortescue was developing had over one-billion tons of proven and probable iron reserves, but would take nearly $3bn of investor capital to access. None of the required infrastructure existed at the time of the investment to successfully tease material from the ground, get it to the coast and loaded on to boats bound for China.
Before FMG could begin shipping iron ore to steel mills in China, a mine had to be developed, a 260 kilometer railroad had to be built, a new port constructed and a turning basin dredged. To fund his dream, Andrew needed to raise $3 billion. Of this required amount shareholders (including Leucadia) provided $900 million and the bondholders $2.1 billion.
Leucadia split its investment between common equity and an unsecured note that would collect 4% of the post-tax revenues from the two mines until 2019. Their success would be tied directly to the outcomes of the projects.
In August 2006, Leucadia invested $400 million in Fortescue Metals Group Ltd (“FMG”). We received 264 million common shares of FMG stock (split adjusted) and a $100 million 13-year subordinated note which receives, in lieu of a fixed coupon, payments equal to 4% of revenues (net of government royalties) over the term of the note.
This structure proved fantastically profitable for Leucadia when the mines came online in 2008. So profitable in fact that Andrew Forrest compelled the Board to sell additional royalty notes at favorable terms as a way of diluting Leucadia’s royalty, a maneuver that ultimately had to be struck down by Australian courts. By 2010, between selling equity and note royalties Leucadia had recouped $349.3 million of its original $452.2 million investment.
During February 2010, we sold 30 million shares of Fortescue’s stock for $121.5 million. We have an old fashioned theory that whenever possible we should retrieve some or all of our initial investment and ride with the significant gains
Prohibited from diluting the impact of Leucadia’s significant royalty checks which would have continued until August 2019, Fortesque undertook a refinancing in 2012 to purchase the note back from Leucadia for the incredible sum of $681 million. The price worked out to a 42% discount rate on the loan’s carrying value on Fortescue’s books of $897 million, which according to the Sydney Morning Herald was “effectively, a reflection of the interest rate being paid.” In the end, Leucadia earned $2.3 billion on its initial investment, a greater than 50% Internal Rate of Return and 5x multiple on investment.
Our six year adventure with Andrew Forrest and FMG was rockier than the Aussie outback, but turned out to be the most financially rewarding
Their exit timing proved nearly equally fortuitous as Australian iron ore spent much of the next decade at lower prices, not that it would have mattered to Leucadia at that point. It seemed as though Leucadia knew that supply would eventually catch up, and while prices may fall they structured their investment explicitly to return capital quickly as production ramped and prices were high. Once they had their capital back they could be mostly agnostic toward the fluctuations of ore prices so long as product continued to flow from the mines.
Is it possible to profit from the commodity cycle? Simply put, maybe. Just as Capital Returns2 implores its readers to focus on the supply dynamics, versus attempting to forecast demand side, we find ourselves in a paradigm where investment constraint is considered virtuous. Is this time different?
Leucadia itself found that supply dynamics could shift quickly as their subsequent investment in National Beef performed poorly when South America entered the beef market, drawn in by rising global demand. They ultimately sold the company to Brazil-based Marfig.
Investors should not expect earnings to grow in line with economy. Rather, they should look out for those rare examples of management who are prudent in their use of capital. The starting point for company analysis is not the outlook for end demand but rather the supply side. Our goal is to find investments in depressed industries at positive inflection points in the capital cycle and in sectors with benign and stable supply side fundamentals. - Capital Returns
I could not have written this without the kindness of strangers who, prior to the days where everything lived online, scanned and uploaded Leucadia’s letters to various value investing message boards. We all owe them a debt of gratitude for their foresight. I am posting the link to the Leucadia letters that I used here but caveat emptor: I have no idea how long it will be live. I recommend pulling down to your own server if you find them of value.
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I would be remiss not to credit an Anonymous Twitter user for their help with this piece, including pointing me to this fantastic VIC post. It is a locked account and I don’t think they are seeking any internet clout, but if you’re reading, thanks Mitt!
Worth noting; essentially all of the Capital Returns quotes in this piece are from the Foreword written by Edward Chancellor. I think it is a far better piece of investment writing than all the pages that follow it.