Catch this modern-day gold rush before it's too late

In a gold rush, you should be selling shovels. There is a modern-day gold rush on right now, says James Ferguson, and it's not too late to get in on the action

There are few things more satisfying than getting in early on a really big investment theme, the kind that comes along once every 30 years or so. So I bring you good news. I think that right now we have the chance to do just that. Famously, the way to make money in a gold rush is to sell picks and shovels. These days, mining isn't done by prospectors with turned-up hat brims, but by huge, modern mining concerns with concessions worldwide. The modern equivalent of being a pick-and-shovel retailer is to therefore to own shares in the companies that provide the heavy plant employed by the big mining firms.

Until very recently, commodity companies were suffering horribly. The prices of their products had been falling for 20 years and so had their profits, with the inevitable result that they had failed to invest in their equipment and their capital stock was tired and out-of-date. But all that has changed. We are now seeing a big, sustained upswing in commodity prices: after all these years of neglect and underinvestment, the primary extraction industries (mining and, to a lesser extent, agriculture) can now go on a long-awaited capital-replacement investment binge. The makers of trucks, shovels, diggers, tractors and harvesters are in for a bonanza. So why, then, are these companies all trading at discounts to their near-term earnings outlooks?

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

Rising prices

One answer is that, as far as the market is concerned, big stories take a long time really to sink in. Over the last 200 years, there have been six down cycles in commodity prices, each lasting about 16 to 17 years ­ the last being from 1983 to 2000. Not every one of these downturns was long enough for chronic underinvestment in capital to set in, but they were long enough for the good times to be forgotten. That's exactly what is happening now: the market can't quite believe that it is possible that commodity prices could not only rise, but could keep rising for a decade.

It's probably time to start believing it. Underinvestment by commodity producers usually leads to a drop off in exploration, as well as a fall in the efficiency with which existing resources are extracted. Eventually, after a decade and a half, demand catches up with, and then exceeds, this supply stasis and prices start to swing up once more. This is exactly what is happening now. Historically, each of these upswings lasts between one and two decades. So if the bulls are right, after two decades in the doldrums, commodities are now at the beginning of a multi-year upswing.

Those in any doubt might look at the oil price. Oil led the charge in the last upcycle for commodities and is doing so once again. Prices per barrel have been rising for more than six years, since Christmas day 1998, and even as many hard commodities seem to be hitting a short-term soft patch, oil prices are continuing to defy the naysayers ­ hovering around $60 a barrelTo me, this suggests that the future for the commodity asset class still looks very bright.

Falling costs

But it isn't just rising end-product prices that are boosting the coffers of the oil and mining companies. Before prices started to rise, costs were already falling. Thanks to globalisation, increased productivity, the waning of trade-union power and increased migration, labour's comparative share of the pot worldwide has been in decline since the mid-1970s. Meanwhile, the last two decades of the extended low-inflationary economic boom have driven interest rates and the cost of capital down to levels not seen since the 1960s. Rising prices and falling costs mean profit margins expanding at double the rate.

Picks and shovels

The natural response to higher prices is to boost production as much as possible, and that's just what all the extraction industries are doing right now. The problem is that this takes a mighty toll on all that clapped-out plant and machinery. Already worn out and patched up equipment is run into the ground. With less and less time to take machinery out of circulation for maintenance, rusty heaps that had been nursed along for years are finally giving up the ghost ­ and just at the time when prices and demand are hitting near 20-year highs.

From here on out, demand for new tools and equipment should be robust and price insensitive. 'Get me something to do the job, get it yesterday and hang the expense!' will be the order of the day. Which corporate beancounter would be able to stand in the way of an environment like that? This, then, is exactly the formula for a massive replacement and upgrade cycle in the mining industry ­ an increase in capital spending that only comes along once every two decades.

The beneficiaries of such a once-in-a-generation bumper harvest ­ the makers of heavy and mining machinery ­ have for years been labouring under conditions of sluggish demand and intense price pressure. Such conditions have left just a few industry giants still standing, all experts at surviving in a low-margin world. Yet such a surge in demand will allow them not only to enjoy inflated order books, but also to demand higher prices. Profit-margin expansion could be spectacular. Below, we name some of the shares you should be looking at to get in on the action.

Four shares to buy now

Caterpillar (CAT) is a $35bn company that makes construction, mining, agricultural and forestry machinery. The share price has more than doubled since its late October 2002 low, but since that time, when the business outlook was at its bleakest, consensus profit forecasts into the medium term have more than trebled, from $1.25 to more than $4.50 a share. And it's not just the potential from the mining industry that will drive earnings eitherCaterpillar is also set to benefit from a massive new $290bn, six-year US highway plan.

Up until the end of last year (when the share price hit $49.36), the stock was tracking the improvement in the earnings outlook reasonably closely. However, since then the share price has struggled with the psychologically important $50 barrier, where it still trades.

That, though, should change: the near-term business scenario just keeps getting better and better, and at some point the market is going to realise that the sector is seeing a major sea-change. On a prospective price/earnings ratio of just 12 times, ahead of what could be a once-in-a-generation opportunity, Caterpillar looks far too cheap. Deere & Co (DE) is even cheaper, trading as it is at $70, 11 times this year's forecast earnings and more or less the same price it was at in November. Deere has quite an exposure to agricultural machinery too, which may be holding it back, but even here the rise in soft-commodity prices is starting to boost the earnings environment. Note that the chief executive of un-listed German combine harvester maker Claas just announced that the company was expecting 'double-digit growth in sales and profit this year', according to the FT. Claas is the world's third-largest combine harvester manufacturer after Deere and CNH (also a US firm).

Another company to look at is Japan's Komatsu (ticker number 6301), which makes construction and mining machinery, including hydraulic excavators, bulldozers and wheel loaders. Since April 2003, the stock price has doubled, yet the profit outlook has absolutely soared. Prospective earnings per share have surged from near zero to nearly 70 a share, putting the stock on a price/earnings ratio of just 13 times this years profits.

This may not sound such a great bargain, but the apparent earnings growth is running much faster and the improvement potential is arguably that much greater. Added to that, Komatsu's earnings-per-share outlook just keeps getting revised higher. In October of last year, consensus forecasts for this fiscal year were for 40; by April, this had risen to about 55, and today analysts can see the company making 71.4. Even this number only reflects a recurring profit margin of less than 7%. Revenues and margins can still expand from here.

One other name that must be mentioned is Bucyrus International (BUCY). The company makes large excavation machinery used for surface mining, including walking draglines, electric mining shovels and blast-hole drills used for mining coal, iron ore, copper, bauxite, phosphate and other minerals. Only listed on 22 July last year, Bucyrus is perhaps the purest play on mining machinery. Much smaller than the other companies listed above, and with a market cap of just $774m, it has also fallen under the radar of a lot of investors. It is trading on 13 times next year's forecasts.

Bucyrus made just 39c per share last year, but already analysts' consensus forecasts are for $2.22 this year and $2.87 in 2006. Yet the share price is unchanged on last November and down 20% from March's highs. This is the most geared play on a mining-sector reinvestment programme, and could yet prove to be the true sleeper in the group.