Continuing from our previous article, What is the meaning of ?oversold?? Part 1: Technical analysis perspective, we will explain the meaning of “oversold” from the value-investing perspective.

In Are some Aussie resource stocks oversold?, Pete, our regular reader commented that,

So on one hand, if demand is the same, then they are oversold, but on the other hand, if demand is decreasing, then even though they are currently oversold, the current oversold price may become a nominal price in the near future?
Eg: BHP shares may be worth $40 now, but trade at $35 or so. But due to lack of demand, by December, they may only be ‘worth’ $35. Although by then my guess is that they would be oversold even more to $30, etc.

On that note, when we say the resource stocks might be oversold, is it perhaps a bit like real-estate, where they are in fact not oversold at their current prices, but were in fact ‘over-bought’ in the first place, and are now returning to more normal levels? Perhaps they are still overbought now, just less so?

Before you read on further, please make sure that you understand the concept of value investing in our guide, Value investing for dummies. Particularly, pay attention to the first 4 articles. What follows will assume the pre-requisite understanding of these articles in the guide.

The important things to understand about the mining business is this:

1. It’s revenue is very much dependent on the price of the commodities it sells (this is a very obvious point).
2. It’s a price taker in general. In other words, most mining businesses do not have the market power to affect prices. The exception will be BHP and Rio Tinto as they have enough market power to affect the price of iron.
3. It’s products (e.g. copper, zinc) is relatively very much un-differentiable from those of their competitors unlike the more traditional businesses.
4. A mining business do not have an theoretical infinite life as some other traditional businesses. That is because ALL mines have a finite amount of the commodity that can be economically extracted. In other words, there is a finite life to every mine/oil/gas field at a specific rate of extraction.

The problem is, the future earnings of a mining company is notoriously difficult to predict. For example, these factors will affect the future earnings:

1. Commodity prices (that’s obvious point).
2. Cost of its input (energy is one of the major inputs and that in itself is a commodity whose prices are at the mercy of the markets).
3. Exchange rate. Since commodity prices are denominated in US dollars, an Australian mining business’s earnings will be dependent on the exchange rate.
4. The future quantity of the commodities it will produce. Obviously, profits rise when the sale price increases or the quantity of the produce increases. That will depend on the outcome of the development and exploration projects of the mining business.

Within point (1) i.e. the commodity price, there are many factors that will have impact on it:

1. Underlying demand- this is the real physical demand of the commodity needed by people and nations.
2. Investment demand or hoarding- This is the second type of demand in which the buyers and sellers do not have interests in the physical commodity. Instead, they trade the commodity in the context of money shuffling.
3. Physical supply of the commodity- for example, as commodity prices collapses, some mines become uneconomical and close down as a result. This will reduce the supply of commodity produced. Other supply disruptions include strikes, natural disasters and so on. Or there may be new mining projects that start to produce and increase the supply to the market.

Now, let us look at point (1) and (2) that affects the price of commodities. As we explained before in Analysing recent falls in oil prices?real vs investment demand,

Now, let?s go back to oil. What makes up the demand for oil? There are basically two types of demand for oil: (1) The physical demand where the real side of the economy uses for its everyday needs and (2) The investment demand where the financial side of the economy shifts the money here and there from one asset class to the other. We need to ask ourselves the following question: Has the physical demand for oil changed? Will it change in the long run?

In today’s globalised financial system, the investment demand (we like to call it “hoarding” instead) has increasingly significant impact on prices. To complicate the issue, it is very difficult (or impossible, depending on your theoretical inclination) to sift between investment demand and physical demand as the commodity trades are made through complex web of intermediaries and relationships. As we questioned in Price fluctuations and hoarding

In today?s context, does a sudden fall in the price of a commodity (e.g. oil, iron, grain, wheat) mean that its underlying demand has suddenly fallen or its supply has suddenly increased? Obviously, the answer is no.

Let’s say that prices were originally too high because of the artificial demand from investment (or rather, hoarding). Now that the de-leveraging process (see Is the credit crisis the end of the beginning?) is under way, forced liquidation and flight from commodities from these investors/hoarders will send prices down very rapidly. As the change in physical demand/supply of commodities tend to move very much slower (relatively) than the change in investment demand/supply, we believe that this forced selling will tend to cause prices to undershoot (i.e. drop to too low) in the short term.

Now, consider this: as price falls by a lot all of a sudden (due to the sell-off by investors/hoarders), guess what will happen to the physical demand? Obviously, physical demand will increase. To a certain extent, this sell-off will result in a change in the composition of demand (between physical and investment demands). If the miners can increase production in response to increased demand, this will counteract the negative effects of falling prices on profits.

Next, as we mentioned before in Are some Aussie resource stocks oversold?, although commodity prices are falling in US dollars, it has not fallen as much in Aussie dollars.

Another consideration: as investors/hoarders sell commodities indiscriminately, the prices get undershoot. The stock market tends to overreact and price the business as if the prices of commodities will fall even further as rapidly as before. That is, it extrapolates the direction and speed of further commodity price falls too far out. It also tends to ignore the positive counteracting effects on profits as well (e.g. increased physical demand and falling Aussie exchange rate). Now, we will have a second ‘layer’ of price undershooting.

Finally, we will provide a qualifier: it is still possible for commodity prices to fall further in say, 2009 and 2010. But assuming that:

1. Central bankers will eventually resort to money printing (see Understanding the big picture in the inflation-deflation debate) in the context of…
2. … long-run growth in Chinese and Indian demand (see Are we in a long-term inflationary environment?) and
3. Physical demand will not collapse as much and as suddenly in the longer term as the short-term prices seem to suggests, …

… we believe that the long-run earnings of some mining businesses may not be as devastating as what their stock prices suggests. If these resource stock prices continue to plunge further, it will come to a point that it will be priced as if there will be a devastating world-wide Greater Deflationary Depression along with perpetual Chinese/Indian anarchy/revolution/chaos.

But having said that, remember that as we said before, all mines/oil/gas fields have a finite life. In the absence of potential new production from future exploration and mining development projects, a mining business will cease after an estimated number of years, after the supply of commodities are being exhausted. The implication is that if the downturn is severe and long enough, some mining businesses may not last long enough to be able to realise the value of the long-term inflationary trend of commodities. On the other hand, a mining business may choose to ‘extend’ the life of its mines by hibernating (e.g. laying off workers, entering maintenance mode and doing nothing) and waking up when commodity prices are more favourable for production.

A warning though: we are not suggesting that you go out and throw all your entire life-savings into any resource stocks now. Not all resource stocks are undervalued right now. And there is still scope for further commodity price deflation in 2009 and 2010. You have to do your homework and look at each company on a case-by-case basis. Even then, after you have decided which stock to buy, you still have to decide at what price you think it is a bargain. Even then, you still have to decide when to buy. And yet even then, this does not mean that stock prices will not fall further.

We will finish this article with an interesting quote on Jimmy Rogers (see Jim Rogers Talks About Latest Investment Activity) for you to think about:

The bull market [in oil] will not end until somebody finds a lot of oil, or unless we have worldwide economic collapse, perpetual economic collapse…

I will tell you I’ve not sold any oil. Even if it goes to $75, I don’t plan to sell any oil.

Do NOT see it as a recommendation for oil or oil stocks (note that Jimmy Rogers has an interest in oil). Rather, see it as window to his line of thinking.