Skip to the content

The case for buying dirt-cheap commodities

01 May 2013

The biggest profits are made by buying assets when they are cheapest, but only a few investors have been brave enough to raise their exposure to the out-of-favour commodities sector.

By Thomas McMahon,

Senior Reporter, FE Trustnet

Investors should ignore the "doomsters" on the global mining sector and look at the quality of the underlying businesses instead, according to Gerard Callahan, head of UK equities at Baillie Gifford and lead manager of the Baillie Gifford UK Equity Alpha fund.

The commodities sector and miners in particular have been the subject of doom-laden predictions of the end of a super-cycle, falling Chinese demand and a period of over-expansion strangling returns.

In the short-term, data from FE Analytics shows that the FTSE 350 Mining index has lost 17.46 per cent over the past year while the broader FTSE 350 index has made 17.36 per cent.

Performance of indices over 1yr


ALT_TAG

Source: FE Analytics

ALT_TAG However, Callahan (pictured), is holding onto his large positions in Rio Tinto, BHP Billiton and Kazakhmys. He says that most investors are too pessimistic in their thinking on the sector and are allowing short-termism to blind them to its potential.

"We always try to attach lots of caveats to any macroeconomic comments we make since we readily acknowledge that it’s difficult to offer much insight in such an uncertain world."

"We also believe we have a greater chance of adding any value through 'bottom-up' company analysis rather than short-term macro-economic forecasts."

"Having said that, I think it’s also fair to say that we disagree with the growing body of doomsters and continue to remain relatively optimistic that the global economy will provide a reasonable backdrop of resilient demand over the next couple of years."

"The current starting valuations on these mining companies seem to imply that a very pronounced and sustained decline in profitability is imminent."

"Acknowledging all the uncertainties, we remain more optimistic when compared with that view."

Rob Morgan, analyst at Charles Stanley Direct, says that holding mining stocks is surely the truly contrarian call at the moment.

"I couldn’t pick a more loathed area of investment right now than the mining sector, and obviously if you go to your contrarian investor’s handbook you should first find out what everybody hates before investing," he said.

"The story behind it is the mining companies have over-extended themselves in terms of capital expenditure and investing more and more capital, and as demand has weakened, returns have suffered."


"So it’s a bad management story; rather than returning money to shareholders they have invested in unwise capital projects."

Callahan’s £120m fund is a top-quartile performer over three years, having returned 40.98 per cent compared with the sector’s 31.28 per cent, according to data from FE Analytics.

Performance of fund vs sector and benchmark over 3yrs


ALT_TAG

Source: FE Analytics

In keeping with Baillie Gifford’s philosophy, the manager is not afraid to make bold calls against the index or the majority of his peers, and is holding on to his substantial holdings in three large miners, which make up 7.3 per cent of the portfolio.

He says the fund has held these positions for a few years and has not cut them back in response to the sell-off in the sector – in keeping with the fund’s buy-and-hold philosophy.

While Callahan admits that all three have hurt performance in the short-term, he says that taking the long view on these companies, a period of bad management could be a learning experience.

"None of these has been especially helpful to performance recently and especially over the first few months of this year," he said.

"There have been a few more concerns regarding the global economy and over Chinese growth in particular."

"Most commodity prices have fallen this year (to varying degrees) and, consequently, there have been more concerns over the sustainability of current levels of profitability within the mining sector."

"Perhaps only as an aside, it may be less widely appreciated that most of these mining stocks have been out of favour with the broader stock market for several years now (for example both BHP and Rio have underperformed the broader market over periods of five years or more), so there seems to be more going on here than a very recent change in sentiment towards the super cycle."

"We tend to think about these miners in slightly different ways."

"For the large diversified ones, the investment case is more about a broad portfolio of large, long-life, low-cost assets which can generate revenues and profit streams over many decades, through the inevitable vagaries of commodity cycles."

"It also relies on a belief that management can allocate capital sensibly between these large projects, again over a multi-decade time horizon."

"In some cases, those management teams are chastened by some expensive mistakes over the last few years but, when thinking about the next five or 10, a little contrition might just be a good thing."


"In contrast, Kazakhmys is more of a 'special situation', since it is largely a single-commodity play (copper) and the investment case relies on what we hope and expect will be its attractive profile of rising production over the next five years as its new mines in Kazakhstan come on stream."

"Because it will be sensitive to the copper price we expect it will be volatile in the short-term, but over several years we hope it will demonstrate a superior growth profile in its cash-flows."

Morgan says that Callahan’s focus on the long-term revenue and profit streams could be the right way to think about the sector, which is notoriously hard to value.

Iain Scouller, investment trust analyst at Oriel Securities, agrees with Morgan that the sector is the contrarian play of the moment, but he adds that there is a good reason for investing in it for the long-run.

"The sector might perform quite well with significant global inflation. If you get Japan carrying on down its current route and that sort of activity elsewhere, the logical outcome is inflation, which is still what I think is the obvious outcome of this mess."

However, Scouller acknowledges that timing the entrance into such a volatile sector is the main problem.

"It’s a 'trying to catch a falling knife' scenario. The danger is the de-rating continues for another couple of years," he warned.

Rob Morgan says that the way round this is to drip-feed money into the sector.

In an article later today, FE Trustnet will look at some highly regarded funds investors can use to get access to this cheap sector.

Editor's Picks

Loading...

Videos from BNY Mellon Investment Management

Loading...

Data provided by FE fundinfo. Care has been taken to ensure that the information is correct, but FE fundinfo neither warrants, represents nor guarantees the contents of information, nor does it accept any responsibility for errors, inaccuracies, omissions or any inconsistencies herein. Past performance does not predict future performance, it should not be the main or sole reason for making an investment decision. The value of investments and any income from them can fall as well as rise.