Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 130

What to do with resource stocks

On Monday, 28 September 2015 a broker in the UK put out a research note on Swiss-based Glencore suggesting that equity in the company could be worthless thanks to its US$50 billion debt burden. Shares in the company, which runs over 150 mining, oil production and agricultural assets and employs about 180,000 people, fell by 29%, caused BHP and Rio Tinto to fall 6.7% and 4.6% respectively on one day and contributed to wiping A$50 billion off the market capitalisation of the ASX.

Like all fund managers we follow the resources sector closely, as it is the biggest sector in the ASX after the banks. Over the last year, we have travelled to both the hot and dusty mines of the Pilbara and to the Dickensian dark satanic steel mills of North and Western China. In the press there has been much written about the end of the mining boom, and whilst we see that the boom days are over where marginal mines were making supernormal profits, we don’t see that the wholesale dumping of mining stocks is the right move for investors, especially at current prices.

HD-Picture1-161015

HD-Picture1-161015

Resources on the ASX

In pure numbers, metals and mining make up the largest sector on the ASX with 602 mining companies listed. If you exclude the ‘zombie’ companies with market capitalisations less than $20 million, the number reduces to 157 and from this set a mere 16 mining companies listed on the ASX are profitable and pay dividends. Surprisingly, even at the end of the China-led mining boom, there remains A$30 billion of market capitalisation tied up in small unprofitable mining companies.

In any boom there is a transfer of wealth from investors to stock (mining or tech) promoters, stock brokers and service providers (lawyers, bankers and accountants), as hundreds of new companies are spawned. Typically the easiest companies to float are those that either have a project or are exploring for the hot mineral du jour. When I was a chemicals analyst at an international investment bank, I fielded many calls about junior phosphate plays as this was the hot commodity in 2010. Whilst phosphate was a sexy story in 2010, the common theme was very low phosphate ore grades which equate to high processing costs and wildly optimistic estimates of what it would cost to build the necessary infrastructure in the highest cost construction market in the world. For example Legend International (LGDI) estimated that the costs of building their required plant would be only $600 million when the true figure would have been around $1.5 billion, a pretty big ask for a company with $25 million in cash and burning through it at a fast rate. In 2011 this company had a market cap of $200 million and a range of positive broker reports (current market cap $5 million, share price $0.01).

I suspect that for these unprofitable mining companies, the best chance that shareholders have of seeing a return is if their mining hopeful is used by a sexy IT or biotech company as a shell for a backdoor listing on the ASX. Like a stolen Subaru WRX, the ASX-listed shells of tech companies from the late 1990s were re-birthed as mining companies in the mid 2000s and some are likely to turn up as fintech companies in the next few years.

Key factors to look for in resource companies

Prefer the big diversified miners

We prefer to hold our mining exposure in large diversified miners, Rio Tinto and BHP, rather than single commodity stocks such as Newcrest, Fortescue or Alumina. Through the cycle, their diversification by geography and commodity type will give investors fewer headaches than the higher risk pure plays. These companies are well-managed, low cost commodity producers with unhedged reserves in the ground, predominately located in politically secure areas of the world.

Whilst there has been much debate around the sustainability of the dividends for BHP and Rio Tinto, our recent meetings with the management teams post the results in August 2015 gave us comfort as to both the determination of the management teams to maintain these dividends and the ability of the companies to fund them. For example, BHP in 2016 is expected to generate over US$7 billion in free cash flow (after taxes and capital expenditure) which is US$500 million more than the cash flow required to pay a dividend of A$1.75 per share.

 

Own producers rather than explorers

When investing in junior miners, often one of the best things to do is to sell out before they start producing, as this is when the glorious blue sky is interrupted by the harsh reality of construction cost blowouts or miscalculations as to the mine’s ore grades or levels of impurities become apparent. Further as we happen to prefer actual dividends now to promises, we want to own companies producing now rather than those still building major projects or prospecting.

The dramatic fall in the oil price over the past 12 months highlights the desirability for current cash flows over potentially higher returns in an uncertain future. Cash in hand put companies like Woodside in the position to pay off debt, reward shareholders and buy assets off motivated sellers, whereas Origin Energy’s shareholders are facing a dilutive $2.5 billion capital raising done at a 73% discount to where the company’s share price was one year ago.

Low cost volume wins

Whilst higher cost iron ore miners may give the investor the greatest upside exposure to recovering markets, they also give the strong possibility that they won’t survive a prolonged downturn. Every mining boom is littered with the financial wreckage of companies that either had higher costs or were late to the party in bringing on their projects. In August both BHP and Rio reported solid production lifts and production costs per tonne of iron ore of US$16 and US$15 respectively. Significant volume from these large low cost producers will have pushed down prices and will force high cost operators both domestically and in China to cut production and abandon new projects.

Key commodities to look for

At this stage in the resources cycle, investors have to be aware of the market conditions for the various commodities. It is no longer 2006, when China had an insatiable appetite for most commodities. At a mineral level we prefer oil, coking coal and iron ore to aluminium, thermal coal, gold and base metals, primarily due to the superior market structure and limited Chinese domestic supply.

 

 

Hugh Dive is a Senior Portfolio Manager at boutique investment manager Aurora Funds Management Limited, a fully owned subsidiary of ASX listed, Keybridge Capital. This article is for general education purposes and readers should seek their own professional advice before investing.


 

Leave a Comment:

     

RELATED ARTICLES

4 key materials for batteries and 9 companies that will benefit

Why copper prices are at all-time highs

banner

Most viewed in recent weeks

10 little-known pension traps prove the value of advice

Most people entering retirement do not see a financial adviser, mainly due to cost. It's a major problem because there are small mistakes a retiree can make which are expensive and avoidable if a few tips were known.

Check eligibility for the Commonwealth Seniors Health Card

Eligibility for the Commonwealth Seniors Health Card has no asset test and a relatively high income test. It's worth checking eligibility and the benefits of qualifying to save on the cost of medications.

Hamish Douglass on why the movie hasn’t ended yet

The focus is on Magellan for its investment performance and departure of the CEO, but Douglass says the pandemic, inflation, rising rates and Middle East tensions have not played out. Vindication is always long term.

Start the year right with the 2022 Retiree Checklist

This is our annual checklist of what retirees need to be aware of in 2022. It is a long list of 25 items and not everything will apply to your situation. Run your eye over the benefits and entitlements.

At 98-years-old, Charlie Munger still delivers the one-liners

The Warren Buffett/Charlie Munger partnership is the stuff of legends, but even Charlie admits it is coming to an end ("I'm nearly dead"). He is one of the few people in investing prepared to say what he thinks.

Should I pay off the mortgage or top up my superannuation?

Depending on personal circumstances, it may be time to rethink the bias to paying down housing debt over wealth accumulation in super. Do the sums and ask these four questions to plan for your future.

Latest Updates

Investment strategies

Three ways index investing masks extra risk

There are thousands of different indexes, and they are not all diversified and broadly-based. Watch for concentration risk in sectors and companies, and know the underlying assets in case liquidity is needed.

Investment strategies

Will 2022 be the year for quality companies?

It is easy to feel like an investing genius over the last 10 years, with most asset classes making wonderful gains. But if there's a setback, companies like Reece, ARB, Cochlear, REA Group and CSL will recover best.

Shares

2022 outlook: buy a raincoat but don't put it on yet

In the 11th year of a bull market, near the end of the cycle, some type of correction is likely. Underneath is solid, healthy and underpinned by strong earnings growth, but there's less room for mistakes. 

Gold

Time to give up on gold?

In 2021, the gold price failed to sustain its strong rise since 2018, although it recovered after early losses. But where does gold sit in a world of inlfation, rising rates and a competitor like Bitcoin?

Investment strategies

Global leaders reveal surprises of 2021, challenges for 2022

In a sentence or two, global experts across many fields are asked to summarise the biggest surprise of 2021, and enduring challenges into 2022. It's a short and sweet view of the changes we are all facing.

Shares

2021 was a standout year for stockmarket listings

In 2021, sharemarket gains supported record levels of capital raisings and IPOs in Australia. The range of deals listed here shows the maturity of the local market in providing equity capital.  

Economy

Let 'er rip: how high can debt-to-GDP ratios soar?

Governments and investors have been complacent, even encouraged, the build up of debt, but somewhere, a ceiling exists. Are we near yet? Trouble is brewing, especially in the eurozone and emerging countries.

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.

Website Development by Master Publisher.