A to C: Ok, I have been discussing your potential role in the origin of coronavirus with my friends in the US, Germany and France ^(1a).

C to A: Oh, and I was under the impression that you are my friend. I feel betrayed and won’t buy meat from you anymore ^(1b).

A to C: What! How is that done? I will impose duties on the silicon metal that you were sending my way ^(1c).

C to A: Ok then, no barley for me ^(1d).

A to C: Wow, you want a fight? Here it is; no more zinc coated steel, reinforcing bars, copper tubes or hot rolled coils ^(1e).

C to A: Ok, no cotton, timber or wine for me ^(1f). And just to add insult to injury, I will tweet a morphed picture of your soldiers doing bad things in Afghanistan ^(1g). I know it’s totally incorrect, but we anyways don’t let our citizens see twitter (not that we owe them an answer or anything), but it definitely will be embarrassing for you ⁽²⁾.

A to C: Well, that went downhill quickly. You should be ‘utterly ashamed’. Say Sorry ^(1h).

And instead of tendering an apology to Australia, China’s foreign ministry spokesperson Hua Chunying responded that Australia should feel ashamed of its acts in Afghanistan. From the sequence of events above, it might appear that Australia is the aggrieved party and China the bully. And yet, Australia has ‘patiently sought’ to address tensions in the relationship and wanted direct discussion with ministers.

That is because Australia has a lot at stake. It sends over USD150bn worth of goods and services–roughly 7% of its GDP–to China each year. 40% of these exports are iron ore, 10% coal and ~8% education (China’s students coming over to study). In comparison, China’s exports to Australia are only ~USD50bn, accounting for a minuscule percentage of its GDP. Clearly, China has the edge on economic grounds.

Among other things (weak USD against other currencies, rising liquidity, higher demand and cyclically tight supply), the rising strain in the relationship between Australia and China is leading to commodity prices soaring to levels not seen in the past seven years. Iron ore prices have risen to USD133 per ton (from recent lows to USD75/t in Mar20 and USD40/t in Jan-16). Copper prices have rallied 65% since Mar-20, zinc 52% and aluminium 43%. For many of these commodities, China has imported raw material only to export finished goods back at a price that does not make sense for a lot of international players (we had discussed this at length here: link). Continued tension with Australia could result in China losing access to cheap raw materials, which in turn is likely to trigger a supply crunch not witnessed for a while now.

Investing life would have been easier had things been that simple. For example, Australia is dependent on China as it exports USD60bn worth of iron ore to the latter, but 60% of China’s iron ore requirements come from Australia (~600mn tons each year). China has been trying hard to replace that for a while now and its overtures in Simandou (interiors of Guinea, Western Africa) have been to that effect.

Nevertheless, that site will require billions of dollars to develop, which includes building a 700km rail link to port. Optimistic estimates peg project completion in five years, but a few in the mining industry put it at 10 years. In the short term, China could look to Brazil as an alternate source (currently supplies 20% of its requirement), but at the current juncture that’s not a priority as it is busy battling corona virus. Eventually, economics solves all puzzles. If you want peace, make nations trade-a corollary to Frédéric Bastiat’s quote, “when goods do not cross borders, soldiers will,”-and commodity prices will sober down once China and Australia become BFF again and as activity slows towards the start of the Chinese new year.

In the meantime, however, the NSE Metals Index has risen c35% over the past month compared to c11% returns in NSE Nifty (and is now outperforming the Nifty even on calendar year to date basis). When you boil it down to individual companies, it is starker. Over the past 13 years, India’s oldest and amongst the most respected private steel companies Tata Steel has delivered near zero returns. Nonetheless, in bouts, it has been stellar – returning over 250% thrice (in the same period and up 50% in just the past month). This brings us to the bigger question, how important are cyclicals in one’s portfolio? Have investors, over the past few years, given undue importance to structural growth stories at the cost of cyclical businesses?

We have argued several times in the past (link, link, link, link) that one cannot expect a unitary investment framework (buy good companies at any price or only buy companies with RoE higher than X% and margins higher than Y%, don’t buy PSU businesses, don’t buy commodity businesses, etc.) to deliver superior investment returns over a longer horizon. If there was one (or even a few) investing hack(s) to beat the market, it (they) would have been discovered over the past 90 years of institutional investment history.

In our investment framework, we essentially deploy a judicious mix of strategies, which involves sizeable exposure to these cyclical businesses (not just commodities like metals and cement, but long-term cyclicals like commercial vehicles). By design, we have no ambition to buy those businesses at their absolute bottom and sell them at the absolute top of cycle. And still we have realised that exposure to cyclicals generates superior returns versus not having them in the portfolio.

Notes:
(1) Timelines: (a) 21 April 2020 (b) 11 May 2020 (c) 13 May 2020 (d) 18 May 2020 (e) 30 June to 27 July 2020 (f) 16 Oct to 20 Nov 2020 (g) this week (h) 30 Nov 2020
(2) Australian soldiers are facing an inquiry over possible war crimes in Afghanistan: https://www.theguardian.com/australia-news/2020/nov/26/australian-soldiers-sent-show-cause-notices-after-afghanistan-war-crimes-report

Disclaimers
Information in this letter is not intended to be, nor should it be construed as investment, tax or legal advice, or an offer to sell, or a solicitation of any offer to make investments with Buoyant Capital. Prospective investors should rely solely on Disclosure Document filed with SEBI. Any description involving investment examples, statistical analysis or investment strategies are provided for illustration purposes only – and will not apply in all situations and may be changed at the discretion of principal officer. Certain information has been provided and/or based on third-party sources and although believed to be reliable, has not been independently verified; the investment managers make no express warranty as to its completeness or accuracy, nor can it accept responsibility for errors appearing herein.