Demand for mining companies has surged in recent weeks with a number of top fund managers taking new positions in the sector.
Managers putting their weight behind miners include Jupiter Primadona Growth trust duo Richard Curling and Derek Pound. They said at the end of July they planned to take profits from their stake in BP and reinvest part of the proceeds into the mining sector, which they believe is currently undervalued.
Meanwhile, Schroders’ head of UK equities Richard Buxton completely sold out of Tesco in his £1.9bn UK Alpha Plus fund and replaced the retailer with a mining IPO. He redeployed assets into a new 2% position in mining company Vallar, run by financier Nathaniel Rothschild.
Fundamentals
Nik Stanojevic, equity analyst at Brewin Dolphin, is also backing miners as he thinks sector fundamentals are compelling. He says quality names are doing well and outside a double-dip recession scenario, mining stocks will continue to offer value.
He highlights two schools of thought: “Commodity prices could either remain flat for a while with no improvement or there will be another cyclical upswing with tighter commodity markets driven by continued strong demand from Asia.
“In the first scenario, I prefer stocks with defensive qualities such as high margins and good production growth.
“In the second – a rising commodity price environment – companies with lower margins and higher operating leverage would do better.”
Stanojevic adds if investors are cautiously overweight the sector and believe there will be no double-dip, they might as well go into high quality, safer stocks.
“Investors might as well be overweight quality stocks because if the sector rebounds, they can still participate in the rally, although not to the same extent as if they were in the lower quality names.”
Sovereign debt
Meanwhile, Ian Henderson, manager of the JPM Natural Resources fund, has also been adding to his base metal mining exposure.
He says worries about European sovereign debt, interest rates rising and monetary stimulus being withdrawn led to cuts across the sector and people using gold as a safe haven.
Then when China began to tighten, because of concerns its property market was overheating, there were fears the main driver of commodity prices was going to slow down.
“Commodity prices were driven down because of long liquidation by commercial buyers, which led to a correction in mining stocks. This in turn was exacerbated when people started taking some risk off the table in the second quarter of 2010.
He believes investors have become more optimistic: “We saw some mixed results in Q2 and within the mining space shares became very cheap with some companies trading at 2x earnings, which is just ridiculous.
“They have recovered but they are not up to their previous highs. We are back on a more stable footing today and I think this is going to be a multi-year bull market for commodity producers, which is not going to go away.”
Compelling valuations
Joanne Warner, manager of the £594m First State Global Resources fund, agrees valuations in the sector are compelling.
She thinks investors will look back in three to five years time and think this was an “amazing” period to invest in the resources sector because current valuations factor in an enormous amount of downside.
“Typical consensus earnings for Rio Tinto next year is on EV/EBITDA of less than four – the price you would expect to pay for a company with no growth and a distressed balance sheet which is clearly not the case,” she says.
“You do not need to go far down the size scale to find some attractive investments.”
She says companies might have been cheaper in 2008 during the financial crisis but they are better value now.
“Back then they really did have distressed balance sheets. They had to raise a lot of money through rights issues and asset sales and were in survival mode. Now they have strong balance sheets, good margins, volumes are strong and prices are quite adequate. They are good robust businesses that are being priced as if things are going to get a lot worse.”
From a stock perspective, Stanojevic likes BHP Billiton, which he describes as a “safe company with decent margins, a strong balance sheet, high free cashflow and good production growth”.
He also favours Chilean company Antofagasta though it is restricted as it only mines copper and operations are concentrated in one country. However, he says Rio Tinto is less attractive than BHP Billiton or Antofagasta: “It is midway between leveraged and quality but it has good management.”
For a more speculative buy, Stanojevic recommends ENRC, which produces chrome and iron ore. “It is a company with low operating costs thanks to lower prices in Kazakhstan. But there is some M&A risk around this stock,” he adds.
He says a lot of managers have been buying into Xstrata, which is “much higher beta”.
“It is exposed to bulk commodities and copper and the consensus call is both of these will do well,” he says.
Structural supply/demand
Warner also likes the structural supply/demand profile of copper for her dedicated mining fund. She says in the late 1980s and 1990s a series of major mines were discovered that altered the supply/demand fundamentals of copper and exerted pricing pressures. However, there have been no big discoveries since then and the world is struggling to meet copper demand. Among other stocks she owns in this space are Antofagasta and Anvil.
Warner also favours coking coal, again because of its structural positioning. “It is difficult to get good quality coking coal that can be used for steel production. Chinese steel production has gone from 200 million tones in 2002 to 670 million at the moment, which is underpinning demand.” In this area, the fund has a 2.6% exposure to US-listed Walter Energy.
Henderson has also been adding exposure to the copper miners with stocks such as Freeport McMoRan, Quadra Mining and First Quantum. He says copper has the best fundamentals at the moment of all the base metals.
He has increased his exposure to diversified miners, including buying back into Vedanta, and has funded these positions through a slight reduction in the portfolio’s gold exposure.
“Gold shares were a good place to be when general mining stocks were going down but value appears strongest in base metal and diversified mining producers.
“We have not cut gold exposure enormously but there has been a bit of quieting down of anxieties about the sovereign debt crisis, so the appeal and valuation of base metal producers seems stronger,” Henderson adds.
