Commodities: Equities suffer from dematerialisation
Is recent share-price disappointment a sign of things to come in the extractive industries? Lynn Strongin Dodds finds mining becoming more expensive just as China, one of the biggest commodity markets, begins to reduce its demand
Reports of a sputtering Chinese economy have taken their toll on base metals, while even the star performer, gold, has dipped. These commodities look positively robust, though, when compared to shares in the companies that actually dig them out of the ground: these stocks have consistently underperformed over the last year. There are selective opportunities but fund managers believe that other sectors such as consumer goods and pharmaceuticals offer a more attractive proposition.
"The main reason why we are seeing a drop in the price of industrial metals is because of the slowdown in China," says Bradley George, manager of the Investec Global Dynamic Resources and Enhanced Natural Resources funds. "There is also a change of leadership and the big question of whether the country will have a hard or soft economic landing."
The macroeconomic situation has hit the sector, says Dan Belchers, fund manager at Threadneedle. "A decade ago, gold mining companies were trading at multiples of two to three times net asset value, while base metals were at 1.5 times at their peak," he recalls. "Base metals have slightly underperformed gold mining companies but everything has come down in line."
This is not surprising given that China has consumed vast quantities of industrial metals as part of its urbanisation drive. Last year China accounted for around 40.6% of world demand for aluminium, 38.9% for copper and 36.3% for nickel. It is also the world's largest importer of iron ore, comprising roughly 60% of the seaborne market, while it ranks as the second top importer of coal behind Japan, with a share of 20% of global trade.
The slowdown started last year when China began tightening the monetary screws. While its growth target of 7.5% may be the envy of its western counterparts, it is the country's lowest since 2004. The appetite for commodities has not only diminished but recent reports show that there have been deferrals as well as defaults on cargos of coal and iron ore from some Chinese companies.
Combine this with events in the euro-zone and it is no wonder mining stocks are struggling. The Standard and Poor's metals and mining select industry index (SPSIMM) has plunged 35% over the past 12 months compared with an overall market rise of 2.5%. Prices of copper, nickel, aluminium, iron ore and coal also dropped around 14%.
By contrast the spot gold price rose 6.7% during that same period - and yet the Market Vectors Gold Miners ETF Trust (which comprises producers) slid 23.5% and the Market Vectors Junior Gold Miners ETF plummeted by 46%.
Gold, albeit affected by market trends, has distinct characteristics due to its historical safe-haven status - boosted by the debut of exchange traded commodities (ETCs) about 10 years ago.
Nicholas Brooks, head of research and investment Strategy at ETF Securities, says: "The gold price has outstripped the price of gold equities because investors look at it as an alternative currency rather than a relative value play. We have seen large inflows into our gold ETCs in the past six months due to concerns over Greece. The main attraction of the ETC is the liquidity and that it will be store of value in the worst case scenarios."
Jaspal Phull, portfolio manager at Stenham, says: "There has been a big disconnect between the performance of gold and gold equities. Along with the extreme levels of market volatility, economic conditions have caused additional headwinds for earnings and revenue growth. Input cost inflation has affected mining company earnings, while there are also additional geopolitical risks and issues with operating the mines themselves."
According to Marc Sontrop, portfolio manager of the Melchior Resources Fund, the problems are also down to a combination of producers generally falling short of expectations, government actions and the delay of permits, labour and cost inflation, competition from bullion ETFs and poor mergers and acquisition decisions. He cites the two Kinross deals - the $1.7bn (€1.4bn) RedBack and $1.2bn Aurelian in August 2010 and July 2008 respectively - as examples. Also on the list are Barrick's $7.3bn acquisition of Equinox (primarily a copper company) in April 2011, as well as the Anatolia and Avoca merger in September 2010. "The jury is out on Eldorado's acquisition of European Goldfields and Iamgold's recent purchase of Trelawney," he adds.
Sam Catalano, who manages the Schroder ISF Global Resources Equity fund, says that across the sector one other big problem is that the capital cost of finding and developing new mines is increasing at a faster rate than the underlying commodity prices.
"There is also an increasing demand from investors for higher dividends or buybacks versus mining companies just spending money to get the materials out of the ground," he observes. "There needs to be a better balance between higher returns and capital growth, [and] it is difficult to find that balance."
Companies are reducing their capital expenditure programmes. Industry giants BHP Billiton and Rio Tinto announced in May that they were re-evaluating billions of dollars of development projects on the back of China's slowdown, as well as calls to return funds to shareholders. The two companies, which will account for about a third of total capital investment in the industry this year, are now expected to prioritise their most profitable opportunities and seek to match spending with cash flows.
Others are expected to follow suit. Citigroup recently slashed its forecasts regarding spending in mining infrastructure. Instead of growing by 34% as predicted earlier this year, the figure is now likely to be 13%. The bank canvassed 40 mining companies and found that half were considering lowering their budgets, a huge jump from the 20% who were planning to do so at the beginning of 2012.
Companies will also have to dig deep in order to make up the shortfall in relation to other industries. As George says: "The dividend yield of mining companies are on average 1.5%, but it will need to increase to 3% in order for the sector to be comparable to others and attract the generalist investors. I am not sure that will happen."
Investors should not get too excited, therefore. Rick de los Reyes, mining and metal analyst at T Rowe Price, notes that slowing capex programmes do not necessarily translate into dividends and share buybacks. "Cash flows are not as strong as they were and some companies are looking for a cushion or are building a war chest."
Mergers and acquisitions could give the sector the lift it needs but, like higher dividends, few believe they will materialise. "It is much cheaper to buy other companies with existing production than it is to build new mines," says Neil Gregson, portfolio manager in JP Morgan Asset Management' global equities team. "The opportunities are there and the valuations are low but people are waiting because of the uncertainty in the market."
For those that want to play the sector, Sontrop believes a prudent strategy would be to focus on producing companies with low political risk and companies that have the majority of their capital expenditures behind them. "Higher grade deposits are preferred as they tend to work in multiple commodity price environments and are the last to close down," he says. "Catalyst-rich companies that are not in need of financing over the next 18 months should also outperform their peers."
De los Reyes is more bearish. "Tailwinds are dissipating behind Chinese construction and there is not that much new in the pipeline. As a result the next decade will not be as good as the last decade for commodities. Investors should look at other sectors to generate alpha."