Letter # 56

If I asked you to name the best performing stock in your portfolio over the past five years, what are the chances that you would pick one from the chemicals space? Called by whatever name – commodity, speciality, CRAMS, high performance etc.–on an average, over the past decade, these companies have catapulted 50x. Their historical earnings during the same period have jumped 5x, implying meaningful expansion in valuations.

And the story, you would say, is straight forward, right? Chemicals is a polluting industry; China did whatever it had to do over the past 2 decades and is now incrementally focussed on environment. Plus, post-Covid, the world is tired of the supply chain hassle and wants ‘China plus one’ procurement. Indian companies are well placed in simple as well as complex (or multi-step) chemistry. Plus, managements speak decent English to converse with buyers, labour cost is low, law of the land holds, currency is broadly stable and companies are free to pollute their way to growth. A minuscule move away from China would double revenues of Indian companies. Natural destination… right to win… blah, blah. I will hold these businesses for the next 50 years and valuations don’t matter!

It’s all good and we are in the same boat as the next person; as in, our best performers are chemical companies as well. But what if I were to tell you that the exact same story is playing out in aluminium, and whereas all of us see the chemicals story as “structural”, we view the aluminium price move as “cyclical”. That is to mean that good chemical companies deserve a 30x PE multiple, but metal companies are something of a fad and hence deserve a single digit PE multiple and are generally not worthy of a place in our portfolios for the long term. If you are happy to consider a nuanced take on a complex topic, allow me the opportunity to present my case below.

Aluminium is a reasonably new metal. Unlike steel’s history of thousands of years, aluminium’s history dates back only to early 19^th century, when it was considered ‘holier than thou’ (Napoleon III, the first president of the French Republic, served his state dinners on aluminium plates while the rank and file were served on plates made from gold. Yes, you read that right!).

In the late 1800s, Oberlin College student Charles Hall and French engineer Paul Heroult, separately and simultaneously, developed an inexpensive electrolysis process to extract aluminium from ore. Large amount of electricity was required to power this process, and consequently, production moved to regions where power was cheap. In 1970, NAFTA and USSR accounted for 58% of global aluminium production. By 1998, aluminium production had doubled from 1970 levels, but these countries still accounted for 40% plus of global production. Here is where things started to change.

At the turn of the new millennium, aluminium was THE shiny new metal; it weighed a third of steel, was corrosion resistant, completely recyclable and had good electrical conductivity. It was the metal of the future and all countries creating infrastructure were looking at aluminium with a lot of hope. Sadly, one of those countries was China.

Broadly speaking, to make one ton of aluminium, you need two tons of alumina, four tons of bauxite and 15,000 kwh of electricity. Whereas aluminium smelters and alumina refineries can be built, bauxite and coal (traditionally the fuel for electricity) occur naturally. Historically, therefore, the largest aluminium producing countries were the ones that had access to cheap electricity and bauxite.

That was about to change. In the run-up to 2020, the global aluminium smelting capacity would nearly triple. What was more striking was that China accounted for more than 80% of the incremental capacity. That’s HUGE. For a country that imports bauxite (by my estimate, 40% of bauxite that China requires is imported) as well as coal to generate power only to export aluminium while its domestic companies incurred losses was baffling. I had previously discussed why I believe China expanded the way it did; you can read about it here ⁽²⁾.

Now the thing we conveniently forget is that aluminium is also a highly polluting industry–to make one ton of aluminium, the refinery process (2 tons of alumina) produces around 9kg of air emissions (mainly SO2), 1kg of water emission and over 2000kg of solid waste (red mud). Plus, the anode making produces 2.5kg of air emission, 0.3kg of water emission and 25kg of solid waste. Lastly, aluminium smelting itself produces 23kg of air emission, half a kg of water emission and 34kg of solid waste (landfill) ⁽³⁾.

Last year, China accounted for over 56% of global aluminium production with a carbon footprint that is much larger than rest of the world (given huge transportation for bauxite and coal, plus largely coal-fired power plants). As the Chinese government started clamping down on aluminium production ⁽⁴⁾ to curtail emissions, aluminium prices hit a decade-high this week.

Discussions, even now, revolve around how sustainable these prices are and a large section of investors choose to ignore this sector. Since 2000, however, whereas absolute aluminium prices are up 65%, adjusted for global inflation, they are down 25%. The three listed aluminium companies in India generated a single digit ROCE last year, and two of them are integrated with captive bauxite, and the third one has the lowest conversion cost.

If chemical businesses have rallied for the better part of the past decade, inter-alia on the news that China is serious about reducing emissions, then a similar analogy extends to these aluminium smelting companies as well. Indian companies combined have the production capacity of over 4mt and they trade at single digit PEs. Over the past two months, aluminium prices have moved higher by USD300/t, resulting in an annualized increase in EBITDA by over USD1bn combined.

As many global brokerage houses start pegging next year aluminium prices at over USD3,000/t, which of the below do you think is the right question to ask? (a) should aluminium companies be a part of your portfolio; or rather (b) which aluminium company would you prefer to own?

Notes:
(1) Aluminium and aluminum are interchangeably used in this article and might appeal differently to your sensibilities depending on which side of the pond you are. I am sure my purist colleagues would be kind enough to excuse this liberty at my end.
(2) https://www.buoyantcap.com/capitalist-but-on-my-terms/
(2b) https://www.buoyantcap.com/chemicals-and-commodities-knowing-how-china-operates-can-help/
(3) 46194971.pdf (oecd.org)
(4) METALS Aluminium prices lifted to 10-year high by China concerns | Reuters
This letter was originally published here: View: Should Aluminium Companies Be Part Of Your Portfolio? (cnbctv18.com)

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