The valuations on some of the FTSE 100’s mining stocks have fallen to such depressed levels they are beginning to resemble those on tobacco stocks at the turn of the century, according to Stephen Bailey, manager of the Liontrust Macro Equity Income fund.
Despite its decline in recent years, tobacco remains one of the UK’s best-performing sectors so far this century, due to returns of more than 2,700 per cent between the start of 2000 and its 2017 peak.
Performance of indices Jan 2000 to April 2017
Source: FE Analytics
However, one of the reasons it was able to deliver these gains was because of the depressed valuation it started at, due to the threat of numerous lawsuits in the late 1990s, and Bailey sees similarities with how out of favour the FTSE’s major mining stocks are today.
“I guess a lot of it is to do with the preference for ESG [environmental, social and governance] investing, which is impacting on valuations across the mining sector,” he explained.
“But if you look at Rio [Tinto], which has effectively sold its carbon businesses, you've got a stock there which is priced at 8.5x forward earnings and we think the yield is going to exceed the P/E this year, we expect it to be closer to 9 per cent.
“This is the type of valuation that we saw on tobacco stocks at the turn of the century when Neil Woodford made his name.
“So this for us is an opportunity which is certainly being shunned by investors.”
It is not just the ultra-low valuations that are attracting Bailey to the sector – he said it is also being propelled by major tailwinds that should fuel its growth over the short and long term.
There are four drivers in particular he is excited about: first, a growing global population with a trend towards urbanisation; second, a lack of new supply; and third, the muted impact of the ‘trade war’ – despite pessimism that this could affect demand, the manager said there is no evidence of this so far, noting world steel production is up 3.8 per cent this year.
Last up is decarbonisation and the Paris Agreement, with Bailey pointing out that despite mining’s reputation as a “dirty” industry from an ESG point of view, it will play a vital role in the take-up of electric vehicles.
“There is no electric car revolution without things such as copper, crucial commodities such as cobalt and lithium,” he said.
“The auto industry is obviously going through a huge change at the moment. Of course, if you want to play the electric vehicle theme, investors have looked at Tesla, but with what's going on among the major car giants, no one knows who the winners are going to be.
“You could decide to back BMW or Daimler, you could back a whole host of different car companies. But one thing’s for sure and that is these new cars will contain products such as copper and cobalt.
“So for us, when we look at the miners we see no substitution – they are disruptor-proof.”
Not everyone is so optimistic about the prospects for the sector. In a recent article published on FE Trustnet, Richard Colwell, manager of the Threadneedle UK Equity Income fund, said the miners appear to have been lumped in with quality defensive businesses because of their current cash generation following strong commodity price-rises – despite the risk of future cyclicality.
However, Bailey said this ignores the new approach to capital discipline in the sector, with company management trying to distance themselves from the “gung-ho” attitude prevalent in the supercycle, when their predecessors appeared “hell bent on expansion” at any price.
“Shareholders were taken along a bit of a rollercoaster ride over that decade” he added. “But it's now changed. I think that the focus has been on debt reduction, and there is a new focus on returns to shareholders.
“New capex is certainly very controlled and whereas previously you were seeing a whole host of major projects being worked on, now they are being delivered sequentially.
“We haven't got this wall of capex going on and there's a better understanding as well between managing price and volume.
“The strategy being pursued by the miners now is very healthy, not only for their balance sheets, but also for income shareholders.”
Bailey pointed to the performance of iron ore over the past decade as proof of the effectiveness of this focus on value – the price peaked in 2011 before plummeting. However, the dearth of supply has seen the price of the commodity almost double year-to-date.
Performance of index year-to-date
Source: FE Analytics
“I think that exemplifies the tight nature of a number of these key commodities and how constant demand and low volume growth can actually push these things into a very, very tight supply,” Bailey continued.
“So for us, Rio is the poster boy of the sector: it seems to have led the way and others have followed its approach.”
Data from FE Analytics shows Liontrust Macro Equity Income has made 290.07 per cent since Bailey joined in October 2003, compared with gains of 236.78 per cent from its FTSE All Share benchmark and 212.00 per cent from its IA UK Equity Income sector.
Performance of fund vs sector and index over manager tenure
Source: FE Analytics
It is £100.5m in size, has ongoing charges of 0.91 per cent and is yielding 5.28 per cent.