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The market capitalisation of the All Mining Index relative to the All Industrials suggests it, and a variety of other evidence from a range of sources confirms it: mining is no longer a mainstay of economic activity in Australia. Although it is easy to infer too much [see Value Investing and the (Mis)Measurement of Results], the divergent paths of key ASX indices over the past decade is telling. In mid-1991 the All Mining Index stood at 660; today it is virtually unchanged at 670. The All Resources, which includes oil producers, has risen from 920 to 1,500 (an annualised compound rate of growth of 5.1%); and in even sharper contrast, the All Industrials has risen from 2,600 to 5,700 (8.2%).
On the other hand, and as the robust expansion of the production of minerals, oil and natural gas since the Asian financial crisis of 1997-98 indicates, Australia’s mining and oil industry is battered but not moribund. Indeed, although its relative importance has diminished and it faces a variety of domestic and international uncertainties, the production of minerals and hydrocarbons remains a big business: the Australian Bureau of Agricultural and Resource Economics (ABARE) recently estimated that during the 2000-2001 financial year mining and energy receipts will exceed $40 billion.
Australian mineral and oil producers are also among the country’s biggest earners of foreign exchange. More to the point – and to an extent seldom recognised in cities, well-to-do suburbs and beachfront holiday destinations – mining and other primary production helps to underwrite Australians’ present standards of living. For many years Australians have depended upon steady inflows of capital from other countries in order to finance capital investment (and not infrequently consumer spending). Australia maintains a comparative advantage in primary production; and exports of mineral, energy and agricultural commodities help to recompense these capital inflows and thereby to support the country’s creditworthiness.
Yet despite the size and continued importance of mining, Leithner & Co. has never owned, does not presently own and has no plans to own Australian mining and oil companies. (As a crude but workable definition, for “mining and oil companies” read “No Liability companies on the ASX’s All Mining and All Resources indexes”).
More generally, these enterprises have long tended to comprise disproportionately small percentages of most value investors’ portfolios. Although Guggenheim Exploration Company (which held large interests in various copper mining companies) was the object of one of Benjamin Graham’s first value-based arbitrage operations (in 1915), Graham-Newman Corp. (1926-1955) displayed no particular affinity towards resource companies. Similarly, the investments of Buffett Partnership Ltd included an anthracite company; and Ameranda Hess, Hardy & Harman and Kaiser Aluminium collectively comprised 20% of Berkshire Hathaway’s portfolio of marketable securities in 1979 and 1980 (up from ca. 8% during the late 1970s). But mining companies’ percentage of BRK’s portfolio virtually halved in 1981, fell to ca. 2-3% between 1983 and 1986 and has been zero or close to zero ever since, and oil companies have been conspicuous by their absence. It is well known that Berkshire’s greatest successes have derived not from minerals and energy but rather from insurance and finance, consumer staples and consumer cyclicals.
From this position one should not infer that value investors necessarily regard resource companies as innately poor investments. Indeed, Leithner & Co. is actively interested in certain niche activities ancillary to but distinct from the mining and oil industries. This position does, however, imply that the successful ownership of mining and oil companies requires specific technical skills which by no means all investors (and probably few market participants of any description) possess.
These circulars reason from first principles to conclusions that justify value investors’ tendency to steer clear of resource companies. Borrowing heavily from Carl Menger, Part I and Part II set out two premises underpinning the analysis. From these premises, and borrowing heavily from George Reisman and Julian Simon, Part II and Part III clarify two implications for resource economics. Finally, Part IV sets out a string of implications emphasising the difficulties accompanying any attempt to estimate resource companies’ value.
The series concludes that although at first glance they could not be more dissimilar (indeed, the conventional wisdom places them at opposite poles of a fictitious “Old Economy-New Economy” continuum), in one fundamental respect resource and technology companies closely resemble one another: the estimation of their value is inherently and perhaps insuperably difficult. It is perhaps for this reason that resource and technology shares (more than, say, banking, transport or retail stocks) tend to be playthings of speculators – and have thus been primary objects of the dizzying booms and nauseating busts occurring periodically in Australia.
A Nearly Forgotten Starting Point
Carl Menger (1840-1921), widely recognised as the founder of the Austrian School of economics, published Grundsätze der Volkwirthschaftslehre (subsequently translated into English as The Principles of Economics) in 1871. This book revolutionised both the conception of prices and the understanding of their formation and fluctuation; and although many students have long forgotten (or, alas, never learnt) their origins, several of its premises remain subtly but firmly in place as foundation stones of contemporary mainstream economics. Perhaps most importantly, Menger reasoned from first principles to the conclusion that the prices of goods and services are determined by the extent of consumers’ subjective willingness to pay for those goods and services. Prices, in other words, do not depend – as Adam Smith, David Ricardo and others had contended for a century – upon suppliers’ cost of production or any “labour theory of value.”
Premise #1: “Goods-Character” and Human Action
Tucked away within Menger’s Principles is an insight, innocuous at first glance but with profound implications, which has escaped the notice not just of economists and policymakers but also of private and institutional investors. Simplifying drastically, Menger distinguishes between “things” (which are not owned, to which people impute no economic value and for which prices therefore do not exist) and “goods” (which are owned, to which people do attribute value and for which prices do exist). Things can become goods, and Menger states that any such transformation does not depend solely upon the thing’s physical properties. Rather, it is caused by the human mind’s ability to discover and value the relationship between the thing’s properties and their ability to satisfy particular wants.
By this reasoning, those things present in the external environment in their original states – examples include undisturbed, unmined and unprocessed iron ore, unextracted and unrefined oil and unreticulated water – are not goods. Rather, their “goods-character” must be established by conscious human action. This occurs first through the discovery of the properties that enable a particular thing to satisfy a particular human need(s), and subsequently by the creation of physical control over the thing which is sufficient to satisfy that need(s). More specifically, Menger describes four prerequisites, all of which must be simultaneously present, in order that a thing become a good:
- the existence of an unmet human need;a causal connection between the thing and its ability to satisfy this need;human knowledge of this causal connection;
- command over the thing which is sufficiently direct to satisfy the need.
Iron ore, for example, has been present in the earth’s crust since the planet’s formation. Yet even the most accessible and highest grade iron deposits lay undiscovered and undisturbed, and iron did not begin to become a good, until well after the end of the Stone Age. Moreover, iron was not a ubiquitously available good until the Industrial Revolution was well underway. Iron, then, became a good subjectively and gradually over time. It did so as particular individuals learnt by a process of trial and error that certain reddish deposits on the earth’s surface could, upon the application of certain stages of processing, be fashioned into weapons, ornaments and agricultural implements; as other individuals devised means (technologies) to extract iron ore from below the earth’s surface; as still others devised means to transform lower-grades, mixed grades and complex ores into metal; as steel was invented and methods to manufacture it efficiently were developed; as more and more useful devices (such as rail, motor car and air transport, refrigerators, washing machines, etc.) were devised and improved; and as it became apparent that steel was a sine qua non of these devices’ manufacture.
Similarly, crude oil has existed on and below the earth’s surface for millions and perhaps tens of millions of years, and mankind has known about its existence for thousands of years. Yet oil did not begin to become a good until the latter half of the nineteenth century. Its transformation into a good was also gradual and subjective because human ingenuity and trial and error were required to realise that fuels derived from crude oil could heat homes and power machinery. Time was also required to devise means to refine crude oil so that it could serve these purposes; to invent and improve the engines which petrol, diesel, aviation and other fuels could power; to devise ever more advanced means to detect the presence of oil deposits and to utilise lower quality grades of oil; and to devise means to extract crude from ever more inaccessible locations under the earth and sea.
Menger’s first premise is therefore that a thing’s status as a good is a subjective phenomenon. The transition of a thing into a good requires human action and time. This is because individuals engage in an extended process of trial and error to discover knowledge and (via a market mechanism) to disseminate, improve, cumulate and evaluate it.
...continued in Part II
 
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