Bubble not bust

Materials World magazine
1 Feb 2009

Dr Elena Clarici, CEO of specialist corporate finance boutique CE Cap LLP, London, UK, describes behavioural finance and lessons that mining companies need to learn to survive the global economic downturn.

Many politicians and media reports describe the current credit crisis as a global financial meltdown, and suggest this is the end of capitalism. These predictions are not based on fact, historical or otherwise, but on a natural human response to calamities that appear uncontrollable.

This is not the first time economic ‘disaster’ has occurred, one of the most famous was the South Sea bubble - of 1720, named after the South Sea Company, an English joint stock company that traded in South America, which was given a trade monopoly in South America by the government, who agreed to underwrite the national debt of £30m with an interest rate of five per cent. This caused share prices to soar well above their value, prompting the launch of many companies trying to take advantage of the situation, which was based upon the expectation of exceptional profits because the share price had increased from a few pounds to £1,000/share before falling back.

To stem the drop, South Sea offered to lend money to investors to buy their shares, triggering bankruptcies for those with little credit history who had borrowed the money hoping the share price would recover to former levels. These could be described as sub-prime loans.

The present crises can be described as a bubble rather than a market correction, and invariably will exhibit a well-known, predictable pattern, providing a better idea of what is ahead and how to adjust. Bubbles are as old as investing, and no matter what the asset, the pattern of investor self-delusion persists and the anatomy is understood. As economies have grown, the scale of bubbles has increased until they have become global.

Endless cycle

These bubbles follow a well-defined pattern beginning with a sharp rise in the price of stocks and assets that spark the interest of a wide investor base. This, in turn, attracts more investors, who are often inexperienced, to the market place and pushes up the share price. The higher price is distorted against the underlying asset and fundamental considerations are bent to accommodate the valuation. Investors justify the soaring stock price by reference to a unique aspect of the company or commodity. Eventually market shock or failure causes the share price to fall back and people panic and sell stock, contaminating even sound investments. In time the fears subside and normal market drivers are restored, creating undervalued opportunities for those who base financial decisions on fact, not euphoria.

For example, in the late 1920s, the ‘new economics’ surrounding the hi-tech technology of the day, such as the aeroplane and automotive industries, induced massive public participation and overvalued price-to-earnings ratios that were unsustainable. The ensuing crash wiped 90% off the total market value. In the 1960s and 70s, blue-chip international companies like Kodak, Polaroid and Xerox had high price-to-earnings ratios and appeared so reliable that investors believed they could be bought and held forever. However, the market was flawed and Xerox shares crashed by 60%.

In the late 1980s commentators and investors seeing Japan’s industries as the new global powerhouse. The Nikkei index hit 38,915 in 1989, only to fall to a tenth of this value, and a decade of stagflation ensued. Perhaps the most remarkable bubble was the dot.com boom based on the view that the Internet revolution had transformed the rules of economics to permit permanent rapid growth. Many of the start-up companies had a business plan with no trading or profits, but their shares traded at triple-digit multiples.

If these bubbles are to be prevented, the causes need to be understood. Is it too little regulation, too much speculation and overvaluation, or just excessive excitement in the market? The reality is people are gullible and actively seek information they want to hear. History tells us that recovery does come and it is quick during the first year. However, it is difficult to predict the timing.

People are the problem

Tne way to forecast future trends is to study behavioural finance, an interplay between investing, economics and psychology pioneered by Daniel Kahneman, winner of the 2002 Nobel Prize in economic sciences, and the late cognitive and mathematical psychologist Amos Tversky. Exponents of the science claim to have identified the emotional traits of investors that lead to boom and bust. They maintain that individuals are poorly equipped to be investors as the pain of loss is more intensely felt than the pleasure from gain. Such sensitivity generally makes investors adverse to risk, especially during turbulent times. Investors have a tendency to be influenced and opinion can swing rapidly from one extreme to another.

To ameliorate these traits, investors should revert to fundamentals and admit that equities are a risky asset, traditionally for the brave. They should also recognise that investment is an emotional process and relies upon a discipline, driven by intensive primary research, that can unlock long-term opportunities. This requires distancing from favourite stocks by investors, and from projects by developers.

For mining finance, one of the most risky yet rewarding sectors, investors must alter their viewpoint and face faulty perceptions and biased decision making.

If carried out it will mean a flight to quality, that is to big cap companies able to weather the storm. It will have a negative impact on junior companies that have been the darling of the past mining boom. Some of them became victims of their own success, certainly in the case of AIM-listed shares. There have been too many mining companies going to market at stages too early in their project development, which has led to unfulfilled promise and high expectations with value destroyed, or at best locked. There has also been a surge of new mining ‘experts’ in the mining and financial sectors. Too little was delivered to shareholders.

Going back to basics is likely to be the way forward from this downturn, but with the lessons learnt giving a new listing rationale. This will include greater access to the world of investors, beyond mining enthusiasts, with a greater amount of money raised at the appropriate time to avoid multiple funding. Some exit mechanism must be found to prevent investor entrapment and provide market liquidity. Primarily the company or project must obtain a fair market valuation that realistically reflects its worth.

It may be some time before the lay investor is willing to re-enter the mining sector, in the meantime, finance may be restricted to merger and acquisition, secondary or tertiary listings in more liquid exchanges, or a move to private company status that is not burdened by the stock exchange downturn.

Further information: CE Cap LLP