Investors
P: 1800 658 404
View full details
Financial advisers
Contact your state account manager or our client services.
View full details
Shopping Centres
For leasing, casual leasing and brand solutions enquiries
Contact Us
Connect with us to stay up to date with news and updates.

LinkedIn

What to do with resource stocks


After the large falls in the prices of most resource stocks over the last year, investors might be wondering what to do. Here are a few factors to consider relating to resources at this time of great uncertainty.

On Monday, 28 September 2015 a broker in the UK put out a research note on Swiss-based Glencore suggesting that equity in the company could be worthless thanks to its US$50 billion debt burden. Shares in the company, which runs over 150 mining, oil production and agricultural assets and employs about 180,000 people, fell by 29%, caused BHP and Rio Tinto to fall 6.7% and 4.6% respectively on one day and contributed to wiping A$50 billion off the market capitalisation of the ASX.

Like all fund managers we follow the resources sector closely, as it is the biggest sector in the ASX after the banks. Over the last year, we have travelled to both the hot and dusty mines of the Pilbara and to the Dickensian dark satanic steel mills of North and Western China. In the press there has been much written about the end of the mining boom, and whilst we see that the boom days are over where marginal mines were making supernormal profits, we don’t see that the wholesale dumping of mining stocks is the right move for investors, especially at current prices.

Resources on the ASX

In pure numbers, metals and mining make up the largest sector on the ASX with 602 mining companies listed. If you exclude the ‘zombie’ companies with market capitalisations less than $20 million, the number reduces to 157 and from this set a mere 16 mining companies listed on the ASX are profitable and pay dividends. Surprisingly, even at the end of the China-led mining boom, there remains A$30 billion of market capitalisation tied up in small unprofitable mining companies.

In any boom there is a transfer of wealth from investors to stock (mining or tech) promoters, stock brokers and service providers (lawyers, bankers and accountants), as hundreds of new companies are spawned. Typically the easiest companies to float are those that either have a project or are exploring for the hot mineral du jour. When I was a chemicals analyst at an international investment bank, I fielded many calls about junior phosphate plays as this was the hot commodity in 2010. Whilst phosphate was a sexy story in 2010, the common theme was very low phosphate ore grades which equate to high processing costs and wildly optimistic estimates of what it would cost to build the necessary infrastructure in the highest cost construction market in the world. For example Legend International (LGDI) estimated that the costs of building their required plant would be only $600 million when the true figure would have been around $1.5 billion, a pretty big ask for a company with $25 million in cash and burning through it at a fast rate. In 2011 this company had a market cap of $200 million and a range of positive broker reports (current market cap $5 million, share price $0.01).

I suspect that for these unprofitable mining companies, the best chance that shareholders have of seeing a return is if their mining hopeful is used by a sexy IT or biotech company as a shell for a backdoor listing on the ASX. Like a stolen Subaru WRX, the ASX-listed shells of tech companies from the late 1990s were re-birthed as mining companies in the mid 2000s and some are likely to turn up as fintech companies in the next few years.

Key factors to look for in resource companies

Prefer the big diversified miners

We prefer to hold our mining exposure in large diversified miners, Rio Tinto and BHP, rather than single commodity stocks such as Newcrest, Fortescue or Alumina. Through the cycle, their diversification by geography and commodity type will give investors fewer headaches than the higher risk pure plays. These companies are well-managed, low cost commodity producers with unhedged reserves in the ground, predominately located in politically secure areas of the world.

Whilst there has been much debate around the sustainability of the dividends for BHP and Rio Tinto, our recent meetings with the management teams post the results in August 2015 gave us comfort as to both the determination of the management teams to maintain these dividends and the ability of the companies to fund them. For example, BHP in 2016 is expected to generate over US$7 billion in free cash flow (after taxes and capital expenditure) which is US$500 million more than the cash flow required to pay a dividend of A$1.75 per share.

Own producers rather than explorers

When investing in junior miners, often one of the best things to do is to sell out before they start producing, as this is when the glorious blue sky is interrupted by the harsh reality of construction cost blowouts or miscalculations as to the mine’s ore grades or levels of impurities become apparent. Further as we happen to prefer actual dividends now to promises, we want to own companies producing now rather than those still building major projects or prospecting.

The dramatic fall in the oil price over the past 12 months highlights the desirability for current cash flows over potentially higher returns in an uncertain future. Cash in hand put companies like Woodside in the position to pay off debt, reward shareholders and buy assets off motivated sellers, whereas Origin Energy’s shareholders are facing a dilutive $2.5 billion capital raising done at a 73% discount to where the company’s share price was one year ago.

Low cost volume wins

Whilst higher cost iron ore miners may give the investor the greatest upside exposure to recovering markets, they also give the strong possibility that they won’t survive a prolonged downturn. Every mining boom is littered with the financial wreckage of companies that either had higher costs or were late to the party in bringing on their projects. In August both BHP and Rio reported solid production lifts and production costs per tonne of iron ore of US$16 and US$15 respectively. Significant volume from these large low cost producers will have pushed down prices and will force high cost operators both domestically and in China to cut production and abandon new projects.

Key commodities to look for

At this stage in the resources cycle, investors have to be aware of the market conditions for the various commodities. It is no longer 2006, when China had an insatiable appetite for most commodities. At a mineral level we prefer oil, coking coal and iron ore to aluminium, thermal coal, gold and base metals, primarily due to the superior market structure and limited Chinese domestic supply.

About the author
Hugh Dive is a Senior Portfolio Manager at boutique investment manager Aurora Funds Management Limited, a fully owned subsidiary of ASX listed, Keybridge Capital. This article is for general education purposes and readers should seek their own professional advice before investing.
Taking your SMSF to the next level
Download now
This content is provided by Cuffelinks and does not represent the views of AMP Capital.

Sign up to our newsletter!

Receive regular insights and marketing communications including a weekly update of trending news and market insights that are tailored for SMSF trustees and investors.
Sign me up
AMP's Australian operations are bound by the current Australian privacy legislation which outlines how organisations should manage and use personal information collected and held about their customers. AMP Privacy Policy

Thanks for subscribing

Thank you for subscribing to our weekly highlights newsletter.
Your privacy is important to AMP Capital and we are bound by the current Australian privacy legislation. View our privacy policy
Submit and close

Sign up to our newsletter!

Receive regular insights and marketing communications including a weekly update of trending news and market insights that are tailored for SMSF trustees and investors.
AMP's Australian operations are bound by the current Australian privacy legislation which outlines how organisations should manage and use personal information collected and held about their customers. AMP Privacy Policy
Sign me up Not right now. Thanks

Sign up to our newsletter!

Receive regular insights and marketing communications including a weekly update of tending news and market insights that are tailored for SMSF trustees and investors.
AMP's Australian operations are bound by the current Australian privacy legislation which outlines how organisations should manage and use personal information collected and held about their customers. AMP Privacy Policy
Sign me up