Resources: Finessing an inflection in the earnings cycles
Even with the benefit of hindsight, few would have predicted the 34% return from the JSE Resources Index since mid-2013. Back then we were facing domestic disruption – the threat of AMCU had emerged on the labour front in the gold sector and was growing in the platinum sector following the 2012 Marikana tragedy at Lonmin. Globally, we were facing the threat of tapering of monetary stimulus by the US Federal Reserve (Fed), with particular headwinds for precious metal prices (gold) as well as the threat of an increasingly visible and rapidly rising rate of iron ore supply (especially from Australia), which was the last substantial remnant of the so-called commodity ‘super cycle’.
These factors collectively resulted in reduced earnings expectations across the resource sector. This is usually a material headwind to share price performance. The 2015 earnings forecasts for the JSE Resources Top 10 Index specifically were revised downward by 2% according to sell-side estimates.
The reasons behind the resources rally
To look forward to the next 12 months, we must try to understand what drove the 34% rally, apparently against all odds.
- A weaker rand: Clearly, the weakening rand was a positive driver and a function of the domestic and global headwinds listed above. While we regard a weak rand as a low quality driver of South African mining stocks due to its unpredictability and potential inflationary follow-through, it is a favourable relative driver against JSE equity alternatives. However, global resource stocks also rallied more than 20% on average over this period while US dollar earnings expectations fell approximately 20%. This means that the weaker rand was not the only driver of mining equities.
- Management turnaround on poor capital discipline: The main driver of the re-rating appears to be the mining companies’ realisation of the penalty they faced from investors for poor capital discipline, as reflected in a discounted price earnings rating, and their resulting new commitment to cash flow and shareholder returns. Companies fortunate enough to have passed their capital spending (capex) peak should experience improving free cash flow. Shareholders should see the benefit of this discipline feeding through to capital management in the form of growing dividends, share buy-backs or special dividends. While this appears to be the driver of the re-rating, in the absence of earnings upgrades there is some risk that the earnings cycle remains challenging. As a result, expectations for sector performance and capital management may need to be moderated in the absence of a strong commodity cycle.
- Portfolio restructuring: Without a wave to ride in the commodity cycle, we now see another lever being pulled: companies are increasingly presenting portfolio restructuring ideas, that is, self-help opportunities beyond cost efficiencies and declining capex. For example, BHP Billiton recently announced its intention to spin off its non-core assets, Anglo American Platinum announced its intent to dispose of several assets, and Gold Fields unbundled Sibanye Gold in 2013. Portfolio rationalisation, simplification and ‘shrink-to-grow’ type strategies indicate that we are at the inflection point in the cycle.
We target companies with attractive free cash flow yields
In terms of the outlook, we prefer companies that have an attractive free cash flow yield profile as a result of declining capex and associated improving sales volumes, and rising shareholder returns. We are vigilant for companies with credible self-help opportunities (preferably in relation to underperforming but high-quality assets) and restructuring strategies. Companies can, for example, potentially dispose of assets that currently do not contribute to cash flow and earnings, but that would re-rate on a stand-alone basis.
Avoid companies that rely on an improving commodity cycle
Currently, we generally avoid low quality, operationally geared companies that rely on an improving commodity cycle or weaker rand. Given the re-rating of the sector, we have concerns that some of these stocks are discounting a material recovery in the commodity cycle. In addition, we are cautious when a self-help story is entirely defensive, (for example, where a company cuts capex and operating costs to defend against a deteriorating commodity price.)
Maintain a balanced portfolio
However, there appears to be increasing potential for differentiation in commodity price performance based on the rate of growth in both demand and supply. Base metals currently appear better positioned than bulk commodities and precious metals. This creates the opportunity to enhance a portfolio’s holdings of favourable capex cycle and self-help stories with a favourable commodity price mix.
In terms of valuation, we retain a core value underpin. However, we do not see significant valuation differences between high and low quality opportunities on the balance of short- and long-term valuation metrics.
When investing in cyclical sectors like resources, you should ideally look for companies in the recovery phase of their operating cycle. Such companies are currently rare, so aim to balance a portfolio of stocks where earnings have performed well but normalised valuations do not appear stretched. Select companies that appear well positioned to emerge into a cyclical recovery, but are not heavily stretched on near-term valuation metrics, particularly cash flow and debt. Our top holdings in the Nedgroup Investments Mining & Resource Fund include BHP Billiton, Sasol and Anglo American.
Be responsive to unforeseen dynamics
The operating and regulatory environment is likely to remain challenging, particularly in South Africa. While we hope that the worst of the labour disruptions are behind us for now, we are cognisant that the sector can perform well even in a tough environment, as occurred over the past year. At such points of cyclical inflection, we need to be sufficiently nimble to respond to unforeseen dynamics. We also look for companies to help our investment process by being able to respond themselves (typically from a base of quality assets, good operating performance and proven management response) to risks and opportunities that arise. As a passing thought, the world is resource scarce, and South Africa is resource rich, so opportunities will come to astute investors in the sector.