When making investments in cyclical industries being contrarian can often result in superior returns. Commodities markets certainly fit that mantra, whilst currently offering a positive and improving fundamental outlook. We will discuss a number of the drivers and where we see the best opportunities below. 
A key bullish factor for the overall sector is the continued discipline we see across the sector, but especially from the majors like BHP and Rio Tinto. The focus from the management teams remains on improving the balance sheets and returning cash to shareholders via dividends and buybacks. This is a far cry from the early 2000s when all mining companies were focused on growth, growth, growth. This resulted in the over build of capacity and excess supply that led to a decade of weak commodity prices after the 2008 financial crisis.
Many of these companies remained on life support due to cheap borrowing rates that deferred the rationalisation of supply we normally see through cycles. We are now exiting this extended downturn with many commodities in deficit and very little new mine supply in construction phase.
This means tight supply demand fundamentals look likely to get tighter, as long as global growth can remain in positive territory, with the International Monetary Fund projecting 3.5 per cent growth in 2019 and 3.6 per cent in 2020, this doesn’t look a high risk. This extended downturn has led to a real apathy and fear from investors.
Despite some negative headlines around the fallout from the US-China trade war, global growth has slowed but remains in positive territory. Commodity demand is global, with metals more driven by emerging markets than developed, where recycling is more prevalent. China remains a dominant contributor to demand, but a fall out from US China trade war rhetoric has led greater geographical diversification, with the likes of Vietnam and Indonesia major beneficiaries of manufacturing looking to diversify away from China. At the same time India’s growing middle class and evolution of its economy will almost certainly drive strong demand growth for decades.
A growing focus on environmental practices is also acting to close existing production and restrict capacity additions. This is a multi-year trend that looks likely to exacerbate the tightening fundamentals we discussed above. The recent tragic failure of Vale’s tailing dam in Brazil that lead to over 100 deaths has accelerated this - environmental scrutiny will only increase globally, thus limiting supply of existing and potential new projects.
Poor practices at some mining companies in China had already seen forced closures of zinc, lead and gold mines, with this trend likely to continue. We monitor the environmental standards of our investments closely. This is in part due to the expectations of our shareholders, but also because it is key to whether the company is a good investment in the first place. The impact of poor practices can be materially negative to a share price, not just due to major incidents like Vale’s. Good environmental practices are key to managing social support on a regional basis and governmental support with regards to taxation and permits to operate.
We currently see the most attractive opportunities in the base metal and precious metal miners. Base metals are attractive due to the constrained supply from the long multi-year lead times to build a project, exacerbated by the extended permitting timelines and greater environmental focus, with greater visibility on demand growth. Against this base metal warehouse stocks have continued to fall, with metals like zinc at decade lows of inventory and the copper holdings decline accelerating.
Precious metal miners offer the most attractive valuations at spot gold prices today, especially at the smaller end of the industry. A number of producers and developers trade below 0.5x their net asset value. The closure of specialist resource funds and the respective ETF’s increasing their minimum market caps have left many of these names adrift and unloved. The recent improvement in the gold price has begun to prick the ears of larger producers to M&A, in part due to the accretive value proposition, and partly the mega-mergers of Barrick/Randgold and Newmont/Goldcorp. Any pickup in M&A will close the valuation differential between the larger multi-asset and smaller single-asset producers.
While the sector may have fallen out of fashion with many investors it continues to see improving fundamentals from global growth driving demand, especially in emerging markets, whilst western miners have truly scaled back investment on new projects and an environmental focus globally is curtailing supply. This is why we believe resources provide an opportunity for investors to be contrarian.
Rob Crayford is portfolio manager at New City Investment Managers. All views are his own and should not be taken as investment advice.