Stephen Bailey

Prospecting among the unforgiven miners

Stephen Bailey

Interim results from Rio Tinto this morning (1 August 2018) revealed a 12% increase in underlying earnings, in what Chief Executive Jean-Sébastien Jacques described as a “favourable market environment”. Pleasingly, this allowed the company to announce US$7.2bn of returns to shareholders, with US$3.2bn coming in the form of dividends and buy-backs and US$4.0bn from asset disposals.

We expect the next couple of weeks’ announcements from miners to also show increasing returns to shareholders, making investors’ reluctance to embrace the sector all the more baffling.

The extent of the valuation anomaly has prompted us to initiate a new Macro-Theme, Resource Scarcity, which will be comprised entirely of mining stocks. Our funds already held select mining companies as components of other themes – Infrastructure Spending and Battery Revolution – but our conviction in this investment story means that we are now spinning out a stand-alone theme. In recent weeks, we have upped our exposure to the Resource Scarcity theme by investing in new positions: Anglo American, BHP Billiton and – for our growth portfolios – Canada-based First Quantum Minerals. We already had exposure to Rio Tinto, Glencore and Anglo Pacific. The theme represented 16% of the Macro Equity Income Fund and 17% of the Macro UK Growth Fund at the end of June.

Taken on any valuation metric, the sector is undervalued against historical averages. The FTSE 350 Mining sector is expected to generate a dividend yield of 4.9% in 2018 (Source: Bloomberg), ahead of the 4.0% from the wider index; while it trades on a price/earnings ratio of 11.2, a 20% discount to the market. 

The sector remains out of favour with investors, who recall the commodity ‘super-cycle’ and the related capital indiscipline. During this period, miners ignored shareholder returns and pursued production expansion at any cost. Excessive investment led to overproduction, high debt and falling prices, when demand growth slowed in line with the Chinese economy. We are now more than a decade on from the beginning of these strategic errors and we think it is time for investors to reconsider.

The lessons of the ‘super-cycle’ mean miners now have a better understanding of the perils of overproduction and have addressed balance sheet issues; debt reduction programs, funded by asset disposals and the omission of shareholder returns. Thankfully shareholder returns are now the principle focus. The reassertion of capital discipline and a clearer picture for capital allocation should provide further comfort to the market. The chart below, courtesy of the Financial Times, shows that capital expenditure has shrunk to a fraction of its peak, and is now equivalent to the amount needed to maintain operations.

Stephen Bailey: Miners - the unforgiven - Global mining capital spending 

Source: https://www.ft.com/content/c7353640-72cb-11e8-aa31-31da4279a601

Capex austerity is not only a short term positive for free cash flow, but may also influence pricing and the future balance of supply and demand. We expect increasing demand for certain key commodities as the global economy adjusts to a low carbon future (Electric Vehicles, charging infrastructure & alternative energies). We have written previously about how miners are essential to the operation and manufacture of electric vehicles and believe the lack of current investment in new capacity may cause supply shocks and structural deficits in future years. This period of capex austerity is likely to continue for the next two to three years and should bolster already attractive levels of free cash-flow and drive shareholder returns. Although we are witnessing cost inflation for miners, we feel robust demand and pricing will more than offset these increases. 

China, of course, remains an important factor in the fortunes of miners given that it is the world’s largest consumer of commodities. We see the threat of a trade war between China and the US as background noise and prefer to focus on the favourable macro backdrop. Chinese demand is likely to remain healthy, as the government’s latest stimulus package boosts infrastructure spending.

From a supply perspective, fundamentals are enhanced by Chinese efforts to reduce the environmental impact of production. There has been an unprecedented and robust clamp-down on “dirty” domestic production at Chinese mines, which is causing production costs to escalate to unsustainable levels. It is likely that small to medium sized Chinese iron ore miners will be forced to cease production as their mines become uncommercial to operate. A reduction in domestic supply will certainly benefit seaborne supply from Brazil and Australia. In the short term, we expect to witness stronger pricing as the profitable steel mills of China look to secure supply to meet their demand. Longer term, it will be necessary for this ‘lost capacity’ to be replaced and given the current capex austerity, we see no easy solutions and envisage higher pricing.      

The future looks encouraging for the sector and with current management focused on shareholder returns, it is likely that we may benefit from a sectoral charm offensive fuelled by an expansion of FCF and a stronger pricing environment.

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Key Risks

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Disclaimer

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Wednesday, August 1, 2018, 2:57 PM