First State Investments

Riding the super-cycle and beyond

Originally published in the February 2008 issue

first stateThe eyes of the investment world have been turned to commodities for some time, and while gains have been spectacular some are wondering whether new allocations are now buying at the top of the market. First State Investments believes that there is more upside to come, and more importantly that the expertise of its Australian investment team offers diversification and returns whatever the macro situation. Even as a long only asset management house, First State Investments – the UK-based, European arm of Australian stalwart Colonial First State, itself the investment business of Commonwealth Bank of Australia – focuses on niche markets. The three hedge funds under First State’s wing focus exclusively on global resources, utilising the expertise of a team of fund managers with a scientific and financial background in Australia’s resource economy.

This focus is no coincidence; under London-based Chief Executive Charlie Metcalfe, First State has instituted an explicit policy of moving away from the broad-brush approach under which the firm had struggled to focus on what it believed to be its core strengths. “In Australia we are a household name and part of a very familiar organisation, so it’s only appropriate that we look to provide all the asset classes that an investor would want to include in their portfolio,” Metcalfe explains. “In the UK and Europe, First State clearly does not have that kind of market position and we have moved from being a provider of all things to focusing on what we are good at.”

In practical terms, Metcalfe says: “We consider ourselves to have an edge extending our product range into more specialist offerings covering China and India. A second area where we have an edge is leveraging off our Australian expertise; because of supply and demand in Australia the skill base of investing in natural resources is arguably more developed there than anywhere else in the world.”

First State’s hedge fund managers illustrate this point with some force. Sydney-based Head of Global Resources, David Whitten, has held the role for over a decade on the back of 14 years in financial services as a mining analyst and portfolio manager following his initial training as a geologist. Chris Baker, the other hedge fund manager in Sydney, is a PhD level geologist and has over 20 years experience as a mining analyst and resources investment manager. The third hedge fund manager, London-based Todd Warren, has a background in resources equity research and has been in his role at First State for nearly five years. The impact of this experience -especially in beneficial market conditions for the specialist strategies it deploys – has been clear for First State.


Metcalfe says the firm is the only one to have two funds in the top ten UK performers in 2007, in the form of Global Resources and its India funds, and First State’s overall performance has been reversed in the past few years.

According to the managers, this level of experience also gives First State’s hedge funds a unique perspective on the newly in-vogue commodity arena. “There are new people coming into commodities on the investment side, but there are a very limited number of individuals who have been in the market through three or four cycles,” Baker says. “There are investors who have probably only seen a bull market – if you’ve only been in the space for five years that really will be all you have seen.”

Manager expertise feeds down directly into the First State funds’ investment process, which Whitten describes as being “purely equity investors on long and short sides, with no direct investment in commodities. Our strength is as bottom-up stock pickers, with the shorting process being just the reverse of the expertise we have built up on the long side.”


He explains: “One of our edges is combining industry, scientific and technical skills with our financial backgrounds, which means it is natural for us to have a big focus on site visits. Visiting locations is a key process – no one I know has visited more project locations in the past five years than we have.” Fund managers from First State have visited over 750 resource projects in the past decade and expect to increase this rate as the team grows; there are plans to recruit a fourth hedge fund portfolio manager in the near future.

In the three weeks leading up to The Hedge Fund Journal meeting First State’s fund managers in Sydney, Whitten says team members made site visits to Indonesia, New Zealand, the Philippines, the Congo, Columbia and India, and this level of geographical presence is far from unusual. Naturally this can lead to experiences and investments in some relatively outré outfits; First State’s hedge funds are allowed by their investment criteria to allocate up to 15% of their funds to unlisted opportunities and the fund managers confirm that such holdings are included in their portfolios.


However, market capitalisation can be misleading in the resources sector. “Natural resources companies tend to be small market cap before the money has been spent on building the project infrastructure – that is the point when it becomes big,” Whitten explains. “The commonality in terms of value is the quality of the ore body, whether it is an oil or mining project: the real value is in place even when the company is very small, in what’s below the ground.”

First State sees its intensive tyre-kicking around the world as a major differentiator for its funds.

“Opportunities in this sector are often totally under-researched by the broader investment market before production comes online,” Whitten claims. “Even big projects from large companies are often not visited as often as one might think. An example is the joint Alumina/Alcoa bauxite project in Australia, which had not been visited before the IPO by anyone in the US. This is a Dow Jones stock we are talking about, and the highest returning part of Alcoa had never seen an investment analyst from the US.”

For this reason the First State hedge fund managers argue that, for all the recent focus on commodities as an asset class, the sector is still far from reaching saturation in any part of the process from production, through analysis and broking to investment. One of the funds’ major investment strategies is in-depth analysis of the key revenue streams of the biggest players in the natural resources sector like BHP Billion and Rio Tinto. And although First State is wary of some commodities – for instance copper producers, which the firm believes will be negatively impacted by the US housing downturn, and recently overvalued Chinese mining firms – its managers also make a strong case that the bull market has time to run yet.


Baker says: “When I was a gold analyst in the 90s it was unusual if Australia wasn’t producing three or four new gold mines a year, yet last year there were no new gold mines in Australia. For a long time the mining companies didn’t put any money into a sector they were being told was boring and mature, which has resulted in a chronic under-capitalisation of the supply chain, from the mines to railways, ports, shipping, even tyres for trucks – you can’t get any of these things and it is not a situation I see unwinding in a hurry.”

However, the bottom-up approach makes First State confident in its long-term value proposition and not afraid to tackle questions about its fund prospects if commodities come off the boil. Says portfolio manager Todd Warren: “From a macro perspective clearly this is a cyclical sector; ultimately supply will come in and overwhelm demand, causing commodity price reductions – the issue is when, not if, that occurs. “Having said that, we fall back on how we manage money within the sector: if we were trying to predict commodity prices we would have to be very cognisant of the cycle, but that is not our approach. It’s up to us to educate existing and prospective investors to our process, in order to minimise the outflows when the ‘sex appeal’ of the sector inevitably lessens.”

Trials and tribulations of a global resources manager: negotiating a war zone

There are emerging markets and emerging markets. The average London or New York-based analyst pondering what he or she considers to be the tricky political situation in Russia, for example, might be interested to hear about the pitfalls of oilfield exploration in Papua New Guinea – a country that until recently had not emerged sufficiently to be fully mapped, let alone be safe country for all but the bravest hedge fund manager. According to David Whitten, a series of site visits in the country became “hurried and brief” as a result of a sudden explosion of tribal warfare. He says that protection to the new arrivals was offered in the form of guards armed with bows and arrows, but that this was perhaps not as much use as had been hoped because “when we returned to our huts at night we walked right past the guards unchallenged, as they were all fast asleep in a sitting position – still cradling their bows.”

Or, as Metcalfe says about First State’s overall strategy: “We take comfort from the fact that investors of all kinds are increasingly understanding the benefits of diversification; the notion of being invested mostly in one’s domestic equity market and some bonds is largely a thing of the past. That process includes long term allocations to strategies that will go out of favour – things like property, natural resources and emerging markets. “We find it very interesting that over recent months the credit crisis has caused a lot of investors to look on emerging markets as a safe haven – something that would previously have been considered bizarre.”

Competition growing but space still plentiful

Despite the increasing focus on commodities as an investment class, Whitten says the fund market, especially on the long/short side, remains sparsely populated. While the sector has performed well in recent years it remains a specialist area where experience is valued. “There are signs that newer players will be starting up because of the success of the sector, and we certainly hear of new projects in the pipeline, but it is not easy to replicate the track record of people who have worked in resources for several cycles,” Whitten explains.

In addition, some funds have moved away from long/short strategies as the bull run in resources has continued. As First State has gone through the process of utilising its long only expertise in the long/short arena – opening its three hedge funds at a rate of one a year since 2005 – some competitors have gone the other way.

One of the only long/short resources outfits with a significant Australian presence, the London- and Sydney-based Baker Steel Capital Managers – is understood to have shifted its three gold-specialist funds, which together manage around US$850 million, away from long bias towards strategies close to long only. Baker Steel also allocates directly to commodities, unlike First State which only buys commodity-based stocks.

One of the larger players in global resources investing is London’s BlackRock capital, which manages around US$35 billion in the sector and is also starting to move into long/short commodity investments. Whitten says his team has crossed paths with BlackRock on numerous occasions and considers the firm to have a similar set-up, as a bottom-up stock picker with a rigorous, fundamentals-based approach.

Competition from the US is less visible, Whitten says; although he is aware of a number of funds in that market he says their focus tends to be on energy investments with a domestic focus on both in- and outflows. First State’s genuinely global approach means that the US market has not to date thrown up significant competitors, at least not the kind that First State’s managers have encountered on their ongoing globe-trotting. According to Melbourne-based investment consultant Zenith Investment Partners, First State’s resources funds stand out. Rating the funds ‘recommended’, a Zenith report says they aim to provide “a more consistent return profile than typically generated by resources funds by adopting a much broader investment mandate (ie. long, shorts, pairs and arbitrage trades), [with] returns more linked to the skill of team.”


First State’s investment process in action: Centamin

As far as possible, First State tries to minimise correlation with commodity prices but instead uses the resource analysis skills of its fund managers. As far as possible, First State tries to minimise correlation with commodity prices but instead uses the resource analysis skills of its fund managers to capture returns from the best companies in the sector. The firm’s number one differentiating factor is its managers’ abilities as bottom-up stock pickers and being able to identify future revenue lines before the product is brought out of the ground is absolutely vital. With around 100 total positions in its funds, each stock pick can make a significant difference to First State’s performance


One firm First State has a positive view on – and significant investments in – is the Egyptian-based gold mining concern Centamin, which is triple-listed in the UK, Australia and Canada. As the only gold producing firm in Egypt, Chris Baker describes Centamin as “a bit off the beaten track.”

In the wake of an improvement in the geopolitical situation which made the firm a viable investment prospect, First State was not only the first firm on the ground making an assessment of Centamin’s prospects but, according to Baker, virtually the first institution to even study the newcomer. This fits in with the firm’s ability to assess projects pre-production and its mandated willingness to invest in early-stage projects and smaller market cap firms.

Baker says: “When we first visited Centamin in Egypt – not an easy place to make investor trips to – there was little or no broker coverage, even though the company had market capitalisation in the region of $500 million. It was already a decent sized operation. That meant we had to put valuation numbers ourselves, which is not common to our process but is something we can do when there is no broker coverage.

“We don’t do site visits for inside information like exploration results that haven’t been released yet – that’s pretty much ‘go to jail’ stuff. With Centamin there had been questions asked but I was able to go and look at drill sections and core samples to come away with a very high level of confidence that the ore body existed and that the guys doing the work were very competent.”

The First State managers see Centamin as being in control of a ten million ounce gold reserve with potential annual production of 200,000oz, and hold the firm as a stable long.

First State Investments’ Long/Short Funds

AUM: US$572m
Fund managers: David Whitten and Chris Baker

Inception: 2006
AUM: US$49m
Fund managers: David Whitten and Todd Warren

AUM: US$55m
Fund manager: Chris Baker

Global Resources was the inaugural First State long/short fund, being formed off the back of the success of the firm’s long only commodity investment products. The smaller Global Energy and Global Gold and Precious Metals funds were created to exploit specific advantages within their narrower investment universes using a similar investment strategy to the parent fund.

Fundamental, bottom-up stock picking is key to all three funds, with no investment mandate to take direct exposure to commodity prices through, for instance, allocation to futures or ETFs. This means a long bias of typically 30-70% net, with a limit of 100% gross short exposure out of a total gross exposure allowed of 250% (see Fig.5).

Typical levels, First State says, will be around 165% gross broken down as 115% long, 50% short. Long/short exposure is restricted to 50% net short and 100% net long (see Fig.3).

In terms of positions, an average of 70-130 will be held across a range of strategies in long, short, pair and arbitrage (the resource sector has a high degree of multi-market listings across six main global exchanges which specialise in the sector). The funds invest in the full gamut of market capitalisation and lifecycle of resource firms, with positions taken in the world’s largest mining firms all the way down to some pre-listed outfits.

Position limits are set at 10% in arbitrage, pairs trading and stable long positions in larger-cap companies. Positions of up to 5% are mandated in ‘high conviction’ naked shorts and long-term small- to mid-cap longs, as well as event-driven long positions. Other holdings, including those with potential liquidity issues, moderate conviction allocations and exploration projects, are limited to 1-2% gross exposure.

Gold is a small – approximately US$280 billion – sector with plenty of inherent risk. First State comments that “disappointments are plentiful,” offering shorting opportunities for fund managers with strong analytical abilities on the production side. The sector is also differentiated from other resources by relatively short project lead times – with exploration spend rising, the firm expects volatility tocontinue and to be able to “make money on the way up and down.”