Strategies of Enhanced Investments

Introduction to the Global Commodities strategy

Unlike the approach of traditional banks' investing models Global Commodities recalculates each minute expected profits and cash position of companies in current market environment — nowcasting. The most undervalued companies in terms of EV/EBITDA multiples and mark-to-market earnings are included into target portfolio.
Unlike the approach of traditional banks' investing models Global Commodities recalculates each minute expected profits and cash position of companies in current market environment — nowcasting. The most undervalued companies in terms of EV/EBITDA multiples and mark-to-market earnings are included into target portfolio.
Our Global Commodities strategy invests in major commodity companies involved in resource production and extraction like mining companies (iron, PGMs, gold, etc), food production, fertilizers, HRC steel and so on.

The strategy constantly calculates how much profit (on EBITDA level) each company is probably earning at the moment. Our platform finds the most undervalued stocks considering day shifts in production prices, commodity prices and ForEx.
We launched Global Commodities on May 31, 2020. The strategy shows +65.0% since inception versus S&P500 return is only +40.0%. 1 of 9 our portfolio’s picks even increased by 139.2% in that time.

Prerequisites: excessive expansion of the money supply and lagging prices for commodities

Fact: FED assets increased 8x times from 2007 to 2020, while US GDP increased just 1.5x times. US is printing money and commodities tend to increase in value.

How to use commodity prices to track industry growth?

Frequently, analysts do not change their target prices for stocks based on daily commodity price changes. Generally, a small daily uptick in prices is thought to be due to cyclic shifts in supply and demand that correct down the line.

However, we believe that daily shifts cannot simply be ignored. While some shifts in commodity prices can be written off as temporary — for example, rising coal prices during floods in Australia — others are true signs of fundamental shifts in value.

In early 2021, it would be difficult to say that the increased demand for electric vehicles and a rise in prices for commodities fueling that demand are a cyclical trend. However, in the early stages of industry growth, these shifts in demand would appear in the same way a cyclical change would. Missing these early trends often means a significantly lower ROI.

We do believe it is necessary to estimate fair value of the company every moment, taking into account last market environment changes and time passed since the last reporting date.
For example, if average palladium price in the last reporting period was $ 1600/oz, and the company had profit $ 1 bn last reporting period and it current Market Cap is $ 5 bn, it is much more convenient to be invested in this company in situation when current nickel price is $ 1800/oz compared to situation when it is $ 1300/oz. Moreover, fundamental value of the company in $ 1800/oz market prices environment would be higher.
Why higher? Traditional big banks research would say that fair value of the company is determined based on the DCF approach* and on the long-term price forecasts, while daily commodity price movements should have no influence on fair value of the company.
* Discounted cash flow (DCF) is a valuation method used to estimate the value of an investment based on its expected future cash flows.
Still, in our view the fundamental value would be different due to two factors:
1.
There is some probability that occurred commodity price movement is fundamental (e.g. connected with growing world demand for electric vehicles) and not temporary (in mathematical terms we could say that posterior mathematical probability of the prices in future period would be higher because commodity prices are auto-correlated as can be seen below).
2.
In fact, the company is earning more in current market environment and probably has earned more since the last reporting date, which means its net debt would be lower compared to situation of negative market environment.

Which price shifts are cyclical and which are predictions of growth in the industry?

While we do not fully believe in the ability of traditional market analysts to predict commodity price movements, it is interesting to think of the following:

If certain commodity moves substantially up (or down) — in interest of long-term model, what is better — to imply commodity prices to stay and current prices, or to imply that it would return to historical levels (or to use some average approach)?

To answer that, firstly, we need to understand what parameter we are forecasting. Probably, if we believe that value of the company is discounted NPV (Net Present Value) of its future cash flows, we are interested in forecasting discounted price for the commodity for the next period; let’s take 10 years for this period in frames of our analysis.

We took Worldbank data for key commodity prices since 1960 and tested which approach would better forecast future discounted commodity price (the price that is important for the company valuation).

It is quite obvious that forecasting error is quite high — it is impossible to predict what would happen in the next 10 years.


Commodities
prices analysis


This table shows our average incorrect prediction rate using 3 different approaches.

  • Option 1 — Predictions using average prices over the last 5 years.
  • Option 2 — Predictions using the current spot price.
  • Option 3 — Predictions using the average between the current spot price and 5-year historical price.
The price predictions with the highest rate of accuracy are highlighted in green.

For most commodities, it turned out to be reasonable to use average between current and historical prices.

However, it turned out that for all the resources it is worthwhile to use current market prices in the forecast (compared to using just historical levels). Moreover, for most of the commodities it is reasonable to take average for current prices and historical levels. In additional to increased precision it also reduces risks — when the commodity prices are elevated, the system averages them with historical levels, which helps to avoid buying at maximums (which makes sense given cyclical nature of the commodity prices).

Nevertheless, we did find an exception to this rule: Using current prices without averaging against historical ones turned out to be more reasonable for predicting the prices of commodities that follow trends rather than cycles like oil and gold.

Effects of inflation and currency devaluation on commodities stocks

Inflation may seem like a real portfolio killer, but not necessarily when it comes to commodities.

Usually currencies tend to devaluate in negative market environment (economic problems, falling oil prices, etc). In these moments, quite often market indices and commodity prices are falling as well.

However, based on our experience market substantially undervalues positive effects of devaluation.
Often, commodity prices are measured in US dollars, one of the most stable currencies globally. However, for companies operating outside the US, CapEx and OpEx costs are usually measured in local currencies. This means these commodity companies earn a lot more if they are in a country with an easily devalued local currency — their income remains relatively stable while their operation costs plummet.

For example, Russian commodity companies in our portfolio showed roughly 100% growth in 2015 after the Russian ruble devalued by more than double its 2014 value. In addition, more recently, in the wake of COVID downturns, many commodity stocks showed substantial overperformance. This leaves us with some real opportunities in unstable market environments.

Recently many currencies of developing countries substantially devalued (as can be seen below) which (combined with rising commodity prices) form favorable environment for relevant commodity players and for strategy as a whole.

Approach: nowcasting considering market environment

Generally, we do believe the market undervalues or overvalues the effect of market changes on commodities. By applying a consistent, fundamental approach, we have been able to find market inefficiencies that point to undervalued companies in almost every market environment.

Therefore, if a company is traded cheaply on multiples of its current market value over profits in the current market environment, we do believe it may be undervalued and desirable for investment.

Global Commodities was created as a system that consistently selects undervalued companies in commodity industries poised for growth in the near future. This strategy includes not only the analysis of multiples and financial indicators of the target companies, but, especially, the market environment of the commodities and ForEx markets. Global Commodities is able to find market inefficiencies and select the most undervalued companies in each market environment by applying a consistent fundamental approach. This is a more high-tech solution giving you more deep knowledge opportunities.

In other fields, this is called Now Forecasting (or Nowcasting) — a prediction of the current state of the business.

Nowcasting approach: forecasting the current state of the company

How much does it earn at the moment? What is its net debt, taking into account the market environment and the latest reporting date?

In this respect, we think that it is important to estimate two parameters: how much the company is earning in current market environment?
We constantly recalculate potential earnings for companies, recalibrating our portfolio by the minute-based changes in the current market environment using the capabilities of our platform.
We account for rising commodity prices due to inflation and falling expenses due to devaluations in regional currencies.
Therefore, we estimate potential based on 2 parameters:
1.
How much a company is earning in the current market environment.
2.
The estimated net debt of the company based on:

  • the current market environment;
  • the number of days that have passed since the last reported earnings;
  • the value of dividends paid after the last reported earnings.
Enhanced Investments Approach
  • Prompt recalculating of changes in the market environment, adjusted for risk
  • Objective factors and a uniform system for all companies
  • Immediate response to changes in commodity prices, stock prices and the dollar exchange rates
  • The principle of reversion to the mean for EV/EBITDA multiples is applied
Enhanced Investments Approach
  • Prompt recalculating of changes in the market environment, adjusted for risk
  • Objective factors and a uniform system for all companies
  • Immediate response to changes in commodity prices, stock prices and the dollar exchange rates
  • The principle of reversion to the mean for EV/EBITDA multiples is applied
Traditional Banks Approach
  • DCF models for infinite period
  • Some parameters are subjective (WACC, post-forecast growth rate)
  • The models are based on long-term forecasts of commodity prices and the dollar exchange rate
  • Models are rarely updated
Traditional Banks Approach
  • DCF models for infinite period
  • Some parameters are subjective (WACC, post-forecast growth rate)
  • The models are based on long-term forecasts of commodity prices and the dollar exchange rate
  • Models are rarely updated
For calculations: As stated earlier, we our platform automatically finds markets often either overreact or underreact to small market environment changes. Therefore, we do believe it's important to reevaluate the effects of market changes with a constant and consistent approach.

We use the EV/EBITDA multiple when calculating company valuations for Global Commodities. Compared to other multiple valuations like a pure P/E multiple, EV/EBITDA shows better results as it eliminates some one-off effects from measuring earnings. It also avoids the valuation effect of company debt on the capitalization level (rather than at the earnings level).

Backtest: strong 2.66x S&P500 overperformance

For every company we calculate EBITDА (Earnings before interest, tax and amortization) in current and historical market environment. We take average EBITDA between them, if current market environment is better. Otherwise, (if current environment is worse) we conservatively take current market environment.

We calculate EV/EBITDA multiple using calculated EBITDA, target EV/EBITDA multiple is considered to be historical level of EV/EBITDA for the last 3 years on the 75% percentile level. Investment is being made in all the companies where calculated potential is >10%.

Global Commodities has shown cool results on the back-test, substantially out-performing major indices.
Global Commodities vs S&P500 performance

Backtesting was performed since 01/01/2015 till today. Maximum drawdown could be occurred on 01/20/2016 as -56.2%. In the table below, you can observe strategy’s backtesting returns by year.
Below is the distribution in which companies the system would invest in each period.

This plot map shows us which companies could be included in portfolio accordingly to Rising stars strategy approach.
Portfolio structure dynamics

Returns by company

The table shows following parameters:

  1. How many days we would have been invested in the company in accordance with the tested strategy
  2. Return for the period of being invested in the company in accordance with the tested strategy
  3. Return of being invested in the company for the complete testing period
  4. Annualized (average annual) return of being invested in the company in accordance with the strategy (= (2) ^ (365 / (1)))
Annualized (average annual) return of being invested in the company for the complete testing period

    Actual Performance: 1.63x times S&P500 overperfomance

    We launched the strategy on May 31, 2020, and it showed excellent results: the overall result is +65.0% since launch versus S&P500 +40.0% returns for the same period. 1 of 9 our portfolio’s picks even increased by 139.2% in that time.

    At the moment Global Commodities showed +8.8% this year 2021 versus S&P500 return as +13.4%. Maximum drawdown was occurred on 06/18/2021 as -14.5%.

    Even so, the GC strategy performs good as shown below.
    Global Commodities vs. the S&P 500

    Now the strategy has Sharpe ratio as 1.61. It is used to help investors understand the return of an investment compared to its risk. Sharpe Ratios above 1.00 are generally considered "good", as this would suggest that the portfolio is offering excess returns relative to its volatility.

    Example deals


    • An African producer of PGMs. Excellent conditions on the platinoid market: prices are 16% higher compared to the last 12 months
    • The company trades cheaply on multiples: EV/EBITDA LTM 4.7x, taking into account changes in the conjuncture EV/EBITDA forecasted 3.7x, with a historical multiple >9x
    • At the same time, the company has excellent cash flow generation: the company’s yield in terms of cash flow 19.7% (LTM), forecasted 22.9%

    • A Brazilian mining company
    • Benefits both from higher prices for iron ore, nickel and copper and devaluation of the BRL (leading to cost savings)
    • On EV/ LTM EBITDA is 6.6x with 47% upside. LTM cash flow yield was 7.5%, forecasted taking into account the shift in market conditions is 17.9%

    • Platinum, palladium and gold mining company in South Africa and the USA, backed by reserves for 25 years
    • Product prices are on average 10% higher compared to the last reporting period, while the currency, on the contrary, is 6.2% cheaper
    • According to EV/ LTM EBITDA, the company costs 4.3x, which is significantly cheaper than other players: Barrick 5.9x, Kinross 6.3x, Newmont 12.0x

    • The world’s largest primary producer of platinum, accounting for about 38% of global supply
    • Prices for the company’s products are on average 20% higher compared to the last reporting period, while the currency, on the contrary, is 17.4% cheaper
    • On EV/ LTM EBITDA, the company is worth 5.0x, which is significantly less than the 75 percentile value at 10.5x
    As for 06/22/2021

    SUMMARY

    How do we analyze commodity companies?

    PRODUCTION
    What does the company produce? Is the company increasing production?
    MARKET INVIRONMENT
    What are the current prices for the company’s products relative to the LTM level? What was the historical maximum of prices and under what conditions? What is the consensus on prices in the medium term? Do prices have long-term macro drivers?
    CASH FLOW GENERATION
    Does the company make a lot of money at the FCF level? Does it pay dividends and how much?
    MULTIPLES
    How is the company valued at multiples of value relative to historical levels and peers?
    MODELLING
    Analyzing the structure of the company’s revenue and costs, calculating the expected value of revenue and costs in the current market environment, calculating the value of the EV/forecasted EBITDA multiple
    COMPARING TO PEERS
    How undervalued the company is by EV/forecasted EBITDA in comparison with competitors
    Global Commodities incepted on 2020-05-31;
    Outperfoming S&P500 – actual performance of Global Commodities strategy is +65.0%;
    Sharpe ratio is 1.61;
    Rising commodity prices due to increasing money supply / money printing by FED;
    Falling expenses of global commodity companies due to devaluation of currencies in South Africa, Brazil, Argentina, Russia etc.