BHP Bullish on Commodity Megatrend

Giant iron ore miner BHP Billiton ( BHP - Analyst Report ) reported record revenues and profits Wednesday, citing continued strong demand for steelmaking materials from China as supportive of commodity prices.

Record production and strong margins in their key commodities iron ore, coal, copper, aluminum, and crude oil produced $21.7 billion in profits, a 74% increase over last year.

Here are some highlights from the company's report...

Our decision to invest in our Western Australia Iron Ore business during the depths of the global financial crisis facilitated an eleventh consecutive annual increase in iron ore production, as prices continued to test new highs.

Robust demand, industry wide cost pressures and persistent supply side constraints continued to support the fundamentals for the majority of BHP Billiton's core commodities.

However, BHP Billiton has regularly highlighted its belief that costs tend to lag the commodity price cycle as consumable, labour and contractor costs are broadly correlated with the mining industry's level of activity. In the current environment, tight labour and raw material markets are presenting a challenge for all operators, and BHP Billiton is not immune from that trend.

Despite these near term challenges, we remain positive on the longer term outlook for the global economy. Over the past decade, emerging economies have contributed more to global growth than the developed world and we expect their share to expand as the process of urbanisation and industrialisation continues.

Emerging Economies Megatrend

That last paragraph from BHP is the one to pay attention to if you are taking the temperature of the global economy and wondering how to position your investments over the longer term.

While the US and European economies confirm a softer "soft patch" than we had expected one quarter ago, their saving grace may again be Emerging Markets.

It's a theme I have been a believer in every since I first read of Goldman Sachs strategist ( GS - Analyst Report ) Jim O'Neill and his now iconic "BRIC" approach to global investing which he coined 10 years ago. But it took me a while to learn how to invest in the megatrend of billions of people striving to have the cities, jobs, housing, cars, food, clothes, and entertainment of the developed world.

And it seemed that once I got on board, this little calamity known as the housing/credit bubble came along and wrecked everything. But, the megatrend not only survived the US meltdown, it helped bring us out of our own mess.

Agriculture Megatrend

I wrote in early 2010 that despite fantastic, and fantastically complex, advances in medicine and technology, we may soon call this next ten years something more old-fashioned like "the decade of food."

The idea is that as billions of people shift their diets to more meat-based dishes, food demands multiply by an order of magnitude in terms of inputs. Here's how I summed it up: it takes a lot more soybeans to make a cheeseburger in the city than it does to feed a family for a week in their old way of life.

Remember last year when BHP was denied in its $39 billion bid for fertilizer company Potash ( POT - Analyst Report ) ? While POT is still trading for $7 billion more than that price, CF Industries ( CF - Analyst Report ) made new all-time highs today above $180. It seems this megatrend is ignoring the global slowdown for now.

I wrote about Potash and Bunge (BG) earnings momentum on July 28 in Fertilizer Stocks Growing Profits right before CF crushed it's numbers.

While we are on the subject of BHP's hunger for global commodity profits, I should also mention the drive to expand its energy assets in the U.S. with the acquisition of shale natural gas producer, Petrohawk Energy (HK) for $12.1 billion.

GDP vs. Corporate Profits: A True Disconnect?

The "disconnect" as I've been writing about since the July 29 downward GDP revision, is that with 45% of S&P profits coming from overseas, American corporations are doing well even if domestic demand weakens.

So, short-term we could have recession that takes the S&P down another 20%. Long-term, you wanted to be invested in companies that profit from commodities and related industrial/energy development in emerging economies.

My strategy to play this landscape has been to buy good companies on the dip to S&P 1,100 and either take profits on the swings back up toward 1,200, or hold on the hope we don't get a recession.

The "hope" part of my strategy is only tongue-in-cheek. I don't have to hope. I just have to have a stop-loss placed where the market tells me I'm wrong. For two weeks, my level has been S&P 1,100. That's the cliff. That's the line in the sand between "it ain't that bad" and "it's gonna get worse."

China Tapping the Brakes, Global Investors Lowering Expectations

I've written also in the past two weeks about the potential for a self-fulfilling recession as confidence wanes in the board room and on the investment committee. Confidence is the most precious and most difficult to measure of commodities. Mood swings can devastate markets as we saw in 2008.

The big fundamental wildcards are China's soft landing and Europe's banking crisis. These are hard to have visibility about too. Any week could bring sudden pain that pushes the US economy over the edge.

What might help all investors to think about is the reality of this recovery and expansion. It grew out of an abyss, aided by both Quantitative Easing (QE) and Emerging Markets (EM).

But since that abyss was caused by a systemic generational banking and housing crisis, we should be glad we've recovered as well as we have at all. I've said for two years that this crisis would take at least five years to fully heal, and that's being generous.

Trade the Swings

So what should our expectations be? Markets are complex systems and they will have surges of momentum in both directions as economic forces create cycles. The key is to catch a good chunk of each upswing and take profits so we have cash to redeploy on the downswing.

I think the megatrend of global growth and industrial development is still intact. And even though the wealth transfer from developed economies to emerging ones will continue, US equities should still do well in the expansion phases.

While we wait to see how bad this probable recession could be, investors who can trade the swings and build cash will be rewarded in weeks when the market goes on sale. After this likely push above 1,200 on the S&P 500, sale days will come back again... probably this quarter.

Kevin Cook is a Senior Stock Strategist with Zacks.com