I am sure that we are not alone in wishing to kiss goodbye to 2013, certainly if you have been a bull of mining stocks this year you will likely echo our feelings.
Whilst the wider equity markets have powered on to new record highs, the mining sector has been the (ever) shrinking violet at the party. The one person nobody wanted to speak to and who has disappeared into the corner.
Just why has the mining sector been so unloved this year however? The chart below displays the principal reason very succinctly.
We can see that the earnings for the sector have pretty much collapsed during the last 18 months. This is largely however due to the massive write downs that have taken place to balance sheet carrying values of many of the mining goliaths – Anglo American, BHP, Rio etc and that have had a consequently disproportionate effect on recent earnings. Strip these out and the picture is not quite so bad.
Prices of the 2 primary commodities (ex precious metals) – iron ore and copper – have actually staged a rebound over the last 6 months (see chart below), iron ore in particular while China, the main marginal driver of prices of commodities, continues to grow, and with the exception of peripheral Europe, much of the world is now on a growth trajectory for 2014. This is not usually the environment in which you find falling stock prices in the mining sector.
So what else has been going on to explain the massive falls? Well, it is safe to say that much of the sector will not win any corporate governance awards, what with the shocking shenanigans at Bumi (now renamed, no doubt in an attempt to cast off the past, Asia Mineral Resources) involving missing funds and non payments of debt by corporate executives and the complete farce that was the ENRC takeover. The latter in particular tarnishing those remaining Eastern European & Russia exposed listed stocks with many fund managers now questioning the need to own these companies, irrespective of valuation. The latest corporate saga from this region involves Exillon Energy with an on/off takeover and pass the parcel of large lumps of stock. In short, the sector has been hit with one too many scandals.
What with scandal after scandal, “take unders”, write downs, heads rolling at senior executive levels etc etc, investors could be forgiven for running for the hills.
At Titan however we question the wisdom in paying over 30 times sales for the likes of Twitter and whose valuation is currently $34bn whilst much of the mining sector trades at its lowest price to book ratio since the Great Financial Crisis.
Take a look at the chart below which displays the sector wide Price to Book and also the Dividend Yield relative to the wider market. Pretty compelling picture eh? Certain stocks are even more undervalued compared to the market such as Kazakhmys, much of the gold mining mid and small cap spectrum, Bumi etc. Yes, of course they have their respective fundamental issues, but as ENRC actually illustrated, there comes a time when “it’s in the price”. And some (which was why the founding shareholders took it back private). At Titan, we believe that it “is in the price”. And some.
What do we think is most likely to rise by 50% next year – selected undervalued mining plays or the “momo” tech stocks like Facebook, Netflix, Amazon etc whose PE multiples run to the hundreds of times? Our own money is on the undervalued mining companies.
To gain a wider understanding of just how undervalued relative to its history the sector is, the following chart is a real eye opener. Let us explain what it illustrates.
The chart shows the “trend” earnings for the mining sector over the last 20 years and the sectors present position relative to this with 2 measures overlaid – the PE multiple deviation relative to its historic record and re expressed as a standard deviation measure. A few things stand out to us –
1. The sector is more undervalued relative to its trend than at the nadirs in 2009 and
2. Whenever the sector has swung dramatically either side of its trend it has mean reverted and in fact overshot to the other side.
Remember that this measure also includes the large cap stocks that have actually held up relatively well like Glencore, RIO, BHP etc. Beneath the majors, other stocks have been absolutely decimated and so are even more undervalued.
So, it is a pretty compelling argument that the sector is unloved, under owned and undervalued. But what will be the catalyst to kick-start a re-rating?
Well, the first’canary in the coalmine’ (excuse the pun!) is the increasing amount of directors buying in the sector in recent months. There has been a noticeable pick up and this is a signal worth watching with net buying occurring in contrast to net selling in many other sectors. Prime example in recent days being Anil Agarwil’s nearly £15m commitment of faith in Vedanta where he is Chairman. That’s a pretty punch message in our book!
The second signal is the projected Free Cash Flow yield for the sector (see chart below).
Not unsurprisingly with the sharp asset write downs and scaling back of projects seen this last 4 years, returns on capital are now rising as the profitable companies throw off surplus cash. We have the odd dichotomy, as we can see from the chart above, of the sector projected to produce a higher FCF yield relative to the rest of the market (ex-financials) and yet having the highest dividend yield and lowest PE relative for many, many years. That’s a dichotomy we’d like to exploit. In fact, earnings momentum has already begun to turn positive as the chart below shows.
Finally, with the fund management industry very underweight the sector, a scramble to re-weight could kick off a very sharp rally indeed. We have seen time and time again just how sharp stocks can move when the weight of capital chases them. We would like to be ahead of the queue and not part of the mad scramble.
So, in conclusion we have a fundamentally very cheap sector (on all major measures – Price:book, PE, div yield, FCF) with increased insider buying, positive relative earnings momentum, fund managers en bloc materially underweight and many stocks showing RSI’s in the teens – about as oversold as you can get. If ever we have seen a recipe for a rally in our long experience in the markets, this is it.
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Titan investment Partners hold positions in many of the companies mentioned here. You should not take this piece as an advocation to trade in any of the instruments mentioned and should always take professional advice in relation to your own personal circumstances.
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