Good morning. There are good reasons to expect a quiet week. Recession fears have turned out to be nothing but fear. Earnings season is drawing to a close and the economic data calendar is empty until Jay Powell’s speech on Friday. In short, prepare for turbulence. Email us from your vacation spot: [email protected] and [email protected].

What makes a great stock?

Hendrik Bessembinder is known for showing that stock market returns are the product of a few stocks that do very, very well and a whole lot of stocks that don’t do well at all (see here and here). He recently published a paper discussing which stocks have produced the highest total returns over the long term. The companies on the list, as you might expect, are not only characterized by high annual returns, but also by their longevity (Robin Wigglesworth has a good take on the paper here and was on the podcast to talk about it).

The best-returning stock on the list? Altria, formerly Philip Morris, with a return of 265 million percent since 1925. That makes sense: An extremely addictive chemical and excellent brand management are the recipe for sustained high profits.

The success of the second company on the list is harder to understand: Vulcan Materials has generated 39 million percent returns over the last century, or about 14 percent per year for 98 years. The company has achieved this astonishing record, to put it simply, in its business of turning big rocks into small rocks. Vulcan Materials mines aggregates – crushed stone, gravel, sand – and sells them to construction sites (it also makes concrete and asphalt on the side).

Vulcan (known by the less mythopoetic name Birmingham Slag before 1956) has been a great stock for a long time, but also more recently. It has outperformed the S&P 500 by quite a bit over the last 30 years, and by quite a bit over the last 10 years.

On the surface, the business of turning big rocks into small rocks lacks all the qualities that Unhedged believes make for high returns. It requires owning a lot of physical assets – quarries and heavy equipment. There are no great economies of scale; digging up, crushing, cleaning and shipping the millionth ton of rock is cheaper than the first ton, but it’s still expensive. There’s no intellectual property to speak of and no network effects. The product is a commodity, and not even a scarce one. In short, it’s the exact opposite of the tech stocks that represent the modern model for how wealth creation is supposed to work.

However, the aggregates industry has two interrelated characteristics that are conducive to sustainable profitability: high barriers to market entry and competitive dynamics that are local rather than global.

Mike Dudas of Vertical Research points out that while rocks are plentiful, quarries are not:

In the US, it is difficult to acquire land, go through the environmental assessment to build a quarry, get the permits, and start serving customers three years later. So well-capitalized quarries with a long reserve life that will last for another 40 years and located in areas that benefit from strong demographic trends are a strong advantage.

A well-located quarry faces limited competition, simply because the stone is heavy. It is not worth transporting it very far, so the price is determined by local demand and competitive conditions. Compare this to oil, for example, which is valuable enough to be transported long distances, causing almost all producers to accept a global price. Here’s David Macgregor of Longbow Research:

If you’re shipping a stone product to a job site, you have a 50-70 mile shipping radius. Your competitive dynamics exist within that radius – it’s not a product like cold rolled steel, for example, where there’s a national price.

These two dynamics mean that “this business almost never has a year of falling prices,” says Macgregor. The positive structural characteristics of the business were evident in the second quarter. Aggregates shipments fell 5 percent as the rainy spring slowed construction projects. However, double-digit price increases led to a 2 percent increase in sales and a 6 percent increase in gross margins.

“Commercialization” is a bad word for most investors. But natural resources companies and heavy industrial companies in general are not doomed to generate returns around their cost of capital. This should not be forgotten at a time when investors’ obsession with technology has led the stock market to focus exclusively on this sector.

Oil and the dollar

The rise of the United States as the largest supplier of oil and gas on the world market is generally seen as a good thing. When the swing supplier is a stable country, the market for the most important of all commodities is more predictable. However, the leading role of the United States in production has also changed the relationship between oil prices and the dollar, which could have unfortunate consequences for the global economy.

Until a few years ago, the correlation between oil prices and the dollar was predominantly negative:

This is understandable. Brent, the global benchmark, is traded in dollars, so when the price of oil rises, it takes more dollars to buy oil (that is, the dollar is weaker). At the same time, the dollar tends to fall when the trade deficit increases. When the US imports more, dollars flow out of the country in exchange for other currencies, and the dollar weakens. This was true for oil when the US was a major energy importer.

Since the US is now a net oil exporter, the relationship between oil and the dollar has reversed. In recent years, the correlation between the dollar index and Brent futures has been positive:

This shift is partly structural, partly mechanical and partly accidental. Structurally, demand for the dollar is increasing as more economies buy US oil and gas. Mechanically, the presence of US oil in the market has changed the calculation of Brent futures. Ed Morse, former head of commodity strategy at Citi, now a consultant at energy and commodities firm Hartree, says:

At some point in the last few years, there was no longer enough North Sea crude to settle the Brent contracts, so US oil, which is normally priced via Midland oil contracts, was used for North Sea settlement. So US crude has become more important than Saudi and Russian crude (and) in benchmarks like Brent. Brent is still the same benchmark, but now settles via US crude.

And finally, coincidence. The recent rate hike cycle was necessitated by, among other things, energy price inflation triggered by OPEC production cuts and sanctions on Russian oil. US oil supply exceeded forecasts and filled the gap in global demand. At the same time, however, the US was doing better than other countries, prompting the Federal Reserve to raise rates more than other central banks, increasing global demand for dollars.

While the upcoming Federal Reserve rate-cutting cycle and an end to the war in Ukraine could dampen the trend, the structural and mechanical factors are likely to remain. From Hunter Kornfeind of Rapidan Energy Group:

The US will continue to be a net energy exporter of both gas and oil. We continue to expect crude oil production to increase. The US will continue to be an important supplier to Europe and will continue to play a larger role in the calculation of Brent.

This will have an impact on the global economy. Back when more expensive oil was usually accompanied by a weaker dollar, oil-importing countries paid more (in dollars), but other dollar imports became cheaper. Now countries like Japan are doubly hit, as more expensive oil and a stronger dollar slow growth and raise inflation. It is also a triple whammy for countries with dollar-denominated debt – Kenya is one example. American energy dominance is not an unmitigated global blessing.

(Equestrian)

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