The mining sector has seen renewed interest from fund managers and retail investors in recent months, as buyers hope that the sector can rebound from depressed valuations and benefit from an improving economy.
Performance of indices over 3yrs
Source: FE Analytics
FE Alpha Manager Hambro (pictured right), one of the most highly-respected managers in the sector, says that a number of indicators he is looking for are switching from negative to positive, but a greater number remain either negative or are in a middle ground that is harder to interpret.
Hambro says that at the despair stage of the cycle the last remaining bulls capitulate and the sector bottoms out. During the pessimism stage things start to pick up, with an increasing number of investors tempted but unable to get past the general negativity. Optimism only returns when the majority of the gains have been made.
Of the eight indicators he identifies that the market is in the pessimism phase rather than the despair phase, only one is “flashing green” – the lack of major M&A activity.
Two other indicators are starting to turn green: demand for commodities is starting to outpace supply, after a period in which the miners have been cutting costs and slashing new projects.
“Demand is outpacing estimates,” Hambro said. “For the last year or so it has been ahead of expectations.”
“When you have synchronous global growth there’s a supportive demand background.”
An increasing number of asset sales are also happening, a sign that balance sheets and cash flows are improving.
Hambro says that new management delivering change and new interest in the sector from outside are at an intermediate stage.
“Management hasn’t been in place long, so we’re not at that point yet,” he said on the first point.
“We had the HSBC PMI for China below expectations but shares are already up today,” he added on the second point. “People are looking through the short term challenges and are starting to reduce their underweight, so we are between the two parts of the cycle.”
Indicators that are still at an earlier phase of development – between red for “no” and amber for “in transition” – include write downs in the industry. Hambro says there are still losses to be taken here.
Earnings are starting to stabilise, while balance sheets are starting to improve, with some pain to come.
“Earnings are starting to be upgraded. It’s not just commodity prices that are driving this but also currency moves – namely the significantly weaker Aussie dollar.”
Mining companies are more sensitive to currencies than the commodity prices, the manager explains.
Despite Hambro’s ambivalence on his sector, a number of more broad-based managers are starting to increase their weightings.
James Sutton (pictured left), who sits on the management team of the £1bn JPM Natural Resources fund, says that his fund has “overweighted” the base metal diversified commodity sector.
The fund usually aims to have roughly a third in gold, a third in energy and a third in basic materials and miners, but currently has 42 per cent in the latter. “Cash flow projections are bringing a lot of analysts back to the sector,” he said.
Sutton says that the sector should be re-rated as cash flow estimates are corrected. Sutton expects the fruits of the management changes to feed through in re-calculations of earnings projections.
“There’s clearly a huge amount of scepticism,” he said. “People don’t fully believe these estimates and don’t believe they are no longer fixated on M&A.”
“Many people are still reporting maximum underweights the sector, so it’s improving from a minimum point.”
“If you look at valuations relative to the rest of the equity market they are very cheap.”
Like Hambro, he acknowledges that there is still some work to be done on repairing the companies’ financials.
“This year is going to be about fixing the balance sheets,” he said. “It will allay fears but the real improvements will come through in 2015.”
Sutton say that it is hard to judge where the miners are in the cycle, but on valuation grounds they are worth buying.
“Our companies have been severely beaten up by shareholders after a period of denial, and are being forced to change.”
“From a commodity price point of view we feel we are close to the bottom because these prices are eating into the marginal cost of production.”
Aluminum in particular is trading at price that make production no longer profitable, he says.
This echoes Hambro’s point that demand is starting to outpace supply again.
Ruairidh Stewart, manager of the Martin Currie Global Resources fund, says he has been buying miners steadily over the past nine months on bottom up grounds rather than based on a view on the commodity prices or the cycle.
Glencore is his preferred stock in the sector thanks to its more shareholder friendly policies. With management retaining a 20 per cent stake in the business it was more restrained in its expenditure and more interested in giving a decent return to equity owners, he says.
However, the manager has also bought into BHP Billiton and Rio Tinto, saying that he approves of the changes being made by new management which should improve cash flow.
“We think these new CEOs are aware that their predecessors were fired for poor capital allocation,” he said.
Capex in the industry peaked in 2012, and management teams have made all the right noises about wanting to cut back on expenditure and focus on shareholder returns.
However, Stewart says that this year will be the year where actions speak louder than words: having talked a good game, now it’s time for management to deliver.
“We are looking for costs being taken out of the business,” he said.
One challenge for management will be that their companies are staffed by engineers, who instinctively want to dig more and produce more, the manager notes.
This year is the year to look for improving cash flow and shareholder-friendly dividend or buybacks, the manager says.