Big miners and big yields

Peter Gardner, Plato Investment Management

One chart that tells the resource story well

In asset and sectoral allocation, it is important to examine the big picture, so this chart provides context for the resources sectors against various global equity indices and commodities.

What it shows us today is that NASDAQ has had an exceptional decade and the markets have also performed strongly in the US. World equity has lagged these two as troubles in Europe have held back profit growth.

Over this period, after the super-cycle boom and Global Financial Crisis collapse, commodities have been well supplied. As a result, resource equity performance has been muted and much restructuring was needed after the 2015 downturn to get these companies back into a good position. 

This has been rewarded in the iron ore sector, but generally, this is yet to come as numerous commodities will move into deficit and prices will begin a new up-cycle.

Many resource companies now have robust balance sheets, a tight reign over operating and capital costs, renewed delivery of exploration success and development projects and are prime candidates for renewed investor interest.

Chart 1: Growth of $100 across various indices

Opportunities when broker forecasts lag commodity price trends 

We find that there are extended periods where broker forecasts lag the prevailing commodity price environment, enabling us to take a view on potential earnings changes and share price movements. 

A key example here would be the iron ore trade during early 2019, following the supply disruption from Brazil where we saw around 93mt of annualised production removed from the market. Broker upgrades to Iron Ore forecasts lagged spot pricing and fundamentals for the commodity, where demand was strong and a supply shock saw Iron Ore prices more than double.

Our internal analysis, including site trips to Brazil to better understand the supply constraints, led us to the view that broker forecasts were too conservative and likely to be upgraded over time. 

Ultimately, such broker commodity price revisions drove earnings forecast upgrades for BHP, Rio Tinto and Fortescue, leading share prices higher.

Watch the iron ore price in Australian dollars

The chart we monitor most closely is the Iron Ore price in Australian dollars as this is the primary driver for the profitability of these companies. 

It is commonly known that the iron ore price in US$ has rallied significantly in the last year. This usually coincides with a rally in the Aussie dollar but it is less well appreciated that in this case, the AUD has stayed low, causing the profit margins for Australian miners to increase even more in Australian dollar terms.

An iron ore price of US$80 with the Australian dollar at US$0.67 results in an iron ore price of A$120. At these prices, the Australian Iron Ore miners are highly profitability with the ability to pay out large yields. 

We also monitor the Chinese steel production numbers and port stocks to potentially get a read on future movements in iron ore prices.

How we screen for quality opportunities

Luke Smith, Ausbil Investment Management

There are a number of metrics we focus on in terms of valuations, but our starting point tends to be free cash flow generation. This analysis can be applied to existing producer and development companies under our approach.

A number of the companies outside the S&P/ASX 50 tend to have development projects in their portfolio, and so we typically forecast free cash flow post-ramp-up of projects, so we are comparing them on a like for like basis. 

As an example, Oz Minerals (ASX:OZL) currently produces copper from the Prominent Hill operation, and is in the midst of commissioning Carrapateena. We would assess free cash flow from Oz Minerals including the Carrapateena cash flow, while adjusting for capital yet to be spent on the project.

We term this approach ‘free cash flow divided by fully-funded enterprise value (FCF/FFEV)’, and this effectively means developing and producing companies can be compared on a like-for-like basis. 

An example of where this analysis may be useful is in assessing a development company yet to raise capital for a project. Where such a company might appear cheap purely based on market capitalisation, once you adjust for capital expenditure and working capital, we often find existing producing companies are actually cheaper.

We also review NPV (net present value) of our companies when we value mid-cap miners and EV/EBITDA multiples. Exploration and expansion potential are more subjective measures, but given the depth of experience in the Ausbil Resources team, we do take a view on longer term potential for expansions or mine life extensions in our analysis. At Ausbil, we apply our own top-down commodity price forecasts, but we do compare these to consensus and spot commodity pricing.

5 filters we use and one midcap that passed them

There are numerous metrics and factors that we use to identify and select investments, with the key ones being:

1: Cost of production and the position on the particular industry cost curve. 

We like to invest in companies with assets that are, or will be, in the lower half of the industry cost curve. The factors that drive this will be ore body quality (size, grade, strip ratio etc.) and its location regarding associated infrastructure. We prefer companies that can withstand the commodity price volatility that is so typical of the sector.

2: Asset life is an important factor. 

We generally look for companies with asset lives greater than eight years (and preferably 10 years+) at the time of investment. This longer time frame allows for commodity cycle lows and still provides scope to generate the return on investment. However, many miners have been able to extend mine lives via successful exploration. So while not a specific metric, we prefer companies with extensive exploration acreage near existing producing mines, providing additional exploration optionality.

3: A sustainable margin is an important factor

This combines the concept of low operating costs and the level of sustaining capital required to maintain production, especially at cycle lows. We prefer companies that generate sufficient cash flow to fund ongoing operations, exploration and sufficient cash flow to consider shareholder returns or funding other growth options, without constantly needing additional equity.

4: Balance sheet strength is critical 

A conservatively funded balance sheet is necessary to deal with commodity volatility. While debt is a key factor in funding, we look for companies that have a Net Debt to Equity ratio of less than 50%. If it is higher at the point of investment, we would expect a rapid deleveraging plan, which would only be possible if the asset is “high quality” (high grade, low cash costs, high productivity).

5: Valuation is an important metric 

We tend to use blended metrics, incorporating Price to Net Asset Value, Price to Cash Flow and EV/EBITDA and relative and absolute value, especially for producers. For the development names, the key valuation metric tends to be Price to Net Asset Value.

If we had to name just one of the ex50 miners, Independence Group (ASX:IGO) meets most of the criteria outlined above. IGO’s Nova operation is considered a tier-one asset in terms of operating costs, it has an 8-10 year mine life and within two years of operating has shifted the balance sheet from net debt to materially net cash and rising quickly due to 50%+ gross margins.

The company has consolidated the Frasers Range, the region where the mine is located and is aggressively pursuing the search for the next Nova. While at current levels it looks somewhat fully-valued relative to global nickel peers, its asset quality, rapidly strengthening balance sheet and high exploration optionality warrant the modest premium that it trades at. 

The big picture for the big miners

In our previous wire in this series, we asked our managers what the big drivers of the ASX50 resource stocks will be next year. While trade wars, China's growth and specific projects pose risks to the dynamic, with $100 million of profit per day forecast for the top five miners, it appears that robust cash flow is still set to underpin another strong period. You can read that in full here. 

In the coming weeks, I will be reporting on how the Ten most tipped stocks for 2019 finished for the year, as well as publishing which stocks are the 'most tipped for 2020' in our upcoming survey. Click FOLLOW to get my wires first, and straight to your inbox, at no cost.