Digging for gems in the commodities market

At a high level, the commodities sector appears to be a bright spot in a market ravaged by the pandemic. The S&P/ASX Metals & Mining Index has advanced 7% year-to-date, compared to a nearly 10% fall for the All Ordinaries.

But as investors are well aware, commodity prices don't behave in a homogenous manner. Whereas precious metals such as gold and bulk commodities including iron ore have staged impressive rallies - the likes of oil, lithium and uranium have languished.

With select parts of the commodities universe having delivered astonishing returns over the past five years, is it time for investors to dig around for better value elsewhere? Here, Victor Gomes of Eiger Capital and Ben Clark from TMS Capital discuss this very topic, their process for picking resources stocks and their highest conviction plays in the sector right now.

Notes: Watch, read or listen to the discussion below. This episode was filmed on 12 August 2020.

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Edited Transcript

Vishal Teckchandani: Welcome to Buy, Hold, Sell, brought to you by Livewire Markets. My name is Vishal Teckchandani. The resources sector has been a bright spot in a market that's been ravaged by the pandemic. The S&P/ASX Metals and Mining index is up 7% this year, compared to a nearly 10% fall for the broader index. But now that we know commodities are doing very well, have we missed the boat or is it the case that you need to dig for value in very specific parts of the universe?

Vishal Teckchandani: Joining me to discuss this thematic is Ben Clark from TMS and Victor Gomes from Eiger Capital. Welcome gents.

Where are the opportunities?

Vishal Teckchandani: Victor, I might start off with you. Your funds - it's got a 15% asset allocation, just the commodity sector. Break that down for us. What are the themes that are exciting you the most?

Victor Gomes: Excitement's probably not the word I'd use, but certainly we see opportunities at the moment, mainly in gold, we have gold is the biggest part of the small-cap resources sector. It's about 10% and we're about to index white. So it's not a bullish view, but it has a place in our portfolio given the array of risks that you see out in the market. So that's the majority of our position. And then we've got small positions around a couple of other niche areas.

Vishal Teckchandani: Okay. Well, if we think about the commodities that have performed well, bulk producers have done really, really well. Iron ore has been very, very good this year. Do any of those themes come under your radar?

Victor Gomes: They do. We're a cashflow based sort of a bottom-up stock selector so these businesses have to make sense in a cash flow valuation. Unfortunately, that rules out a lot of small resources because a lot of them aren't actually in the cash-generating position. But in particular bulks, there's actually not a lot to buy in smalls. And that's a problem with small-cap resources that have been hollowed out. You've either had promotions into the big caps and a lot of golds going through the big caps or they've failed. And there's been a few names there that have failed. Or they've been taken out.

Victor Gomes: So in bulks there isn't a lot to choose. For example, iron ore. Now the iron ore price has been very strong over the last little while, as China tries to grow its economy and drive a fixed asset investment. There's not a lot in small caps to give you that exposure. There's no Fortescue in the ... in fact, the best exposure is a mining services company, Mineral Resources. So if you look at the others in there, they're very marginal swing producers, generally high cost. And when the iron ore price is high, they make money. They're a bit like desert flowers, but when it rains, they come out and bloom. When it's dry, they go back in. So it's not an area that we're comfortable in.

Vishal Teckchandani: Okay. Ben, Victor, clearly doesn't like shopping at Costco. He's not a fan of the bulks. What about you?

Ben Clark: Resources has been an area of the market we look at opportunistically is probably the best way I could put it, but we generally hold quite low exposure. So ultimately we try and find businesses that we think have got pricing power and have got some control over their pricing and can grow the pricing of their products or services over time, which of course is the missing ingredient for a lot of resource stocks. But that doesn't mean to say we won't look at it. As we all know, resource stocks go through pretty giddy booms and they go through some pretty scary busts. And we, in the right times, we'll try and find players we think can survive those tough times and confident that the cycle will recover at some stage.

Gold: bullish or bearish?

Vishal Teckchandani: Okay. Speaking of giddy booms, if we think about the one that's booming the most, the most topical it's clearly gold. Cracked $2,000 US dollars. Are you bullish or bearish on gold?

Ben Clark: Oh, well, in hindsight I should have been bullish, but I would be bearish or I'd be mildly bearish at the moment. I just think that the reasons for owning gold are very well understood by investors. And for that reason sentiment plays a big part. I understand why there's a real attraction there, but I just wonder how far this trade can keep playing out. Having said that, I think if there are dips, they will be well supported. Because I think there's a lot of people who have missed that area of the market and there'll be money that comes in off the sidelines. So I'd be pretty wary on gold for me at the moment.

Vishal Teckchandani: Okay. And Victor you've been on the boat, you're riding this wave clearly. How far do you think you can go?

Victor Gomes: As I said, we've got a roughly neutral position, about 10% of the index is gold and that's roughly our portfolio position. We like to see gold as a bit of a hedge rather than a big alpha generator. Having said that, at record Australian gold price, which is almost $3,000, these companies are making massive margins. The cashflow is extraordinary. If you're in production, you've got low costs and you're Australian based, you are doing very well at the moment. So even regardless of your view, now you're obviously having to take a view on the commodity price. And that's the problem with commodities, you are having to take that view, but at the moment, there's you get very fast cash payback on a lot of these producers with these low costs.

Victor Gomes: So they have merit on a cashflow valuation basis. But then in addition to that, there are attributes to gold that provide a hedge to the portfolio that they tend to perform differently to other financial assets. And in this environment of massive global monetary and fiscal stimulus, I think it's sensible to have a bit of gold. It is still an inherent store of wealth. It tends to be mostly independent from most political and fiscal decisions at a local country level. So it has a place, but I agree with Ben, it's one of those hard things, it's very hard to value. What is the fair price for gold? It's very hard to determine that.

Finding quality companies

Vishal Teckchandani: Okay. So let's move on to your investment process and talk about how you find companies with a view to outperform. What are three to four metrics you look for in a mining company?

Victor Gomes: As has been said with miners, you're a hostage to the commodity price. You don't control that. So what you look for, what we look for, again, we're looking for companies that can produce cash flow. So we look for companies that have a low cost and long mine life that makes forecasting a bit easier. We're looking for companies that are generally ex-project or CapEx risk. And I've never met a miner who said that their project was going to be ex and it didn't turn out to be ex plus 20, 30, 50, 100%. That's always the case. They always raise too little equity, their projects go over budget. Then the working capital kicks in and they never make an allowance for working capital. You're building up your stockpiles, you're paying wages. The first ship doesn't leave on time.

Victor Gomes: So you want to see off that project risk. You want to see off commissioning risk and you want a good asset that's got a bit of a track record with some mine life, low cost. And at the end of the day, a great management team, you absolutely need a good management team in this sector.

Vishal Teckchandani: Okay. Ben what about you? And I guess you're in a different part of the process, which is you don't have any exposure to commodities right now. What would it take for you to invest in a commodity company?

Management is key

Ben Clark: Yeah, I'd probably start off where Victor finished off there. I think management is key in mining. When you go out on-site tours of mines, you understand just how complex it is to efficiently, productively run a mine. There are so many things that can go wrong with mining. And there are a select few, I think, a number of CEOs out there who have operationally been outstanding, but it's not just at the physical mining level it's also at the corporate level. We so often see during those boom and bust cycles, a slew of acquisitions at the top of the market and then a slew of asset sales at the bottom of the market. And I think that's an even rarer quality in management is those few that have been good at buying great assets at good prices. So I think Northern Star would be an example for me of a management team that have really excelled in that area.

Ben Clark: And then I'd agree its cost of production, the lower the cost of the production, probably the less risk, but it's also the less upside you get more operating leverage with a higher cost of production. I think you want to see a rising production profile. When it's fairly stagnant you're more at the mercy of what the commodity price is doing. And the balance sheet I think is really important. Getting back to what Victor said there as well, things go wrong in mining. Mines can be shut down for all sorts of reasons and making sure you're in something that can get through those tough periods if a left of field event comes out.

Underperforming commodities: Uranium

Vishal Teckchandani: Okay, let's change gears into commodities which are underperforming. Ben, is there a commodity that you think is yet to have it's a moment in the sun that you're potentially looking at right now?

Ben Clark: I'm not looking at it too closely, but if I threw a left-field idea out there it'd be uranium. Uranium's just a bizarre market where the prices of uranium have been way below even the cheapest producer cost to production for years now. And long-term, that's not a sustainable sort of relationship. We know that demand over time is going to increase. Stockpiles are being wound down, virtually every uranium mine in the world is currently on care and maintenance. And there's been a lot less exploration and all that sort of stuff done because there's just no excitement. There's no funding being accessed by those miners.

Ben Clark: And if you remember back to the early 2000s, this area of the market can go berserk in the right conditions. The question is when? I know some fundies sort of felt that it'll test your patients, but I think there'll be a period where that does come back.

Underperforming commodities: Lithium and rare earth minerals

Vishal Teckchandani: Victor, what about you, a commodity, that's yet to have its moment in the sun?

Victor Gomes: I'd probably throw in two commodities because they're wrapped into one thing. And I know it's a bit contrarian, but I think lithium, I mean, you've seen the Tesla share price, obviously that's been...

Vishal Teckchandani: ...electrifying?

Victor Gomes: It's been electrifying, very funny, but it's been driven by obviously an expectation that they're overcome their problems. And there's been wide acceptance for the product. There are no questions about that. Even though people have doubts about the business model. Clearly, moving down the supply chain, there was a lot of talk about massive expansion in capacity in lithium going back probably two years. And you did see, you saw mineral resources build out Wodjina and then they mothballed it. And then they sold 6.6% of business to Albemarle who are now just simply going to integrate that into their internal lithium change.

Victor Gomes: So you're never going to see that out in the marketplace as a merchant, tonnes of spodumene, which converts into lithium. And you see across the whole gamut of the space, there's been a bit of a CapEx strike, and you see this in resources. And that's what drives the cycle. You get this massive capital that's thrown in because everyone's chasing these high commodity prices, too much capital goes in, and then the commodity prices crash, and then you get no capital. And then it flips around.

Victor Gomes: I think lithium actually has the potential to do that over the next 12 to 18 months. And if there's one thing I like about it, it's that longterm trend. It's hard to pick a commodity price, but you know that if you find the asset that's a tier-one, low-cost global asset - think Rio and BHP with iron ore, those assets make money throughout the cycle. Even though the iron ore price could be $50, they'll make money. At $110 I make a squillion dollars of money, but you find those low cost, large mine, low-cost tier one assets, and you can find them now in lithium.

Victor Gomes: And then on that theme, I'd throw in rare earths and there's really only one name then that's Lynas Corp. And again, it's a unique industry structure, Chinese plus Lynas, that's it globally. And Lynas is one of the lowest-cost producers. It's the second-largest in the world. It's one of the lowest along with one other large Chinese company and it's the most strategically valuable asset in Australia. Whether you'll get paid for it, or I'm not sure, but leaving aside that strategic value because without Lynas a large part of various tech sectors in defence and aerospace globally are really held to ransom by China.

Victor Gomes: Leaving that aside that electrification of transport will happen over the next 10 to 20 years. And it is a key supplier. And what they've proven after spending 700 million of CapEx, building that plant in Malaysia is that this is hard and it takes time and you have to fine-tune and commission it. It will not be replaced easily. I know there are a lot of wannabes out there that say "I've got a project, it's as low cost as Lynas is, and I'll be up and running." Forget about it, it's not going to happen any time soon. So really it's the only game in town. And I think that electrification of transport theme will drive both the lithium price and the NDPR price, which is the key input into making magnets for motors.

Vishal Teckchandani: Okay. Clearly a very strong case for Lynas. I want to talk about a commodity that's really undershot and that's oil. Prices went negative this year. And is this a place that you're just veering away from? What do you reckon about oil?

Oil: Bullish or bearish

Victor Gomes: Oil is one of those sectors in small caps that's really difficult, especially in that there isn't a Santos or an Oil Search in small caps. Again, they're swing producers, just like the iron ore, they're high CapEx. And they need to keep drilling. And especially in unconventional, it fades very quickly. I'm throwing oil and gas into this hydrocarbon. So these worlds fade very quickly you have to drill another hole. So there's some exposure to offshore oil in Australia. Again, it's the same theme. It's there aren't a lot of producers. And if I'm betting on electrification of transport and renewables and replacement of hydrocarbons and fossil fuels, it would be silly to bet on the other side.

Victor Gomes: I actually think it's that trend that's going to support those two will hurt the oil producers over the longer term. And you've seen it in coal. All fossil fuels are on the wane. Oil is probably going to be one of the last that's affected because it's such high utility in oil. It's a fabulous sort of fuel, but it will happen. And I think there are even if it happens slower than I think there's just not a lot of opportunity in Australia to find good ideas.

Vishal Teckchandani: Okay. Victor raises a lot of good points there. Not only is the market in pain, but on top of it's facing disruption. Is the energy sector something you're just staying away from?

Ben Clark: It's probably an area that I think sort of looks reasonably interesting, but it, again, it's like the price of oil was so volatile and it's at that kind of crucial level at the moment where it's right on the lower cost producers costs of production. So they're going to swing pretty rapidly, potentially from profit to making losses. So making sure that you've got a business that's got a balance sheet to withstand another downturn is pretty important. But it does feel to me like asset markets around the world are starting to price in a more rapid economic recovery potentially than we've thought might've been the case a month or two ago. And I would have thought that the price of oil will probably be a beneficiary of that if that does play out to be true.

Ben Clark: So we've seen some carnage in the space, there's been some big delusionary capital raisings that have had to be done mainly in the bigger end of town. So that's also sometimes a bit of a flag that we're closer to the bottom of the cycle.

Ben's high conviction idea: Iluka Resources (ASX:ILU)

Vishal Teckchandani: Okay. Let's bring it all together gents, then what's your highest conviction resources idea that you're putting on your watch list?

Ben Clark: One I've been doing some work on recently is Iluka, which is kind of unusual because what they're in the process they're about to announce in the next half is they're going to spin off this royalty stream that they earned from BHP. So it's called the MAC Royalty and it's over very high-grade block of land that BHP is currently mining iron ore out of. BHP is currently opening up a huge new area of land on this royalty. So you're going to see production coming out of this land rise quite substantially over the next five years, it's called the South Flank Expansion.

Ben Clark: And the royalty, this will be the first time that we've ever had a royalty company trade on the stock exchange. So it's something we've never really seen before. There's a number that trade in Canada and America. The company is planning on paying out 100% of its profit as a dividend to its shareholders. So in this interest rate environment and where the iron ore price is and with the rising production profile, I think it looks really interesting.

Ben Clark: The tricky part is the remainder of Iluka which mineral sands is like it's a really, really hard commodity I think to make money out of. I think they've actually had some really good CEOs go through the Iluka business and they've really struggled to generate any sort of longterm meaningful share price growth for their shareholders. So it's sort of do you wait for the spinoff, which I suspect that some of the two might be worth more than the sole at the moment, or do you buy now?

Victor's high conviction ideas: Lynas Corp (ASX:LYC) & Pilbara Resources (ASX:PLS)

Vishal Teckchandani: Okay. Iluka for Ben. Victor, you clearly also like Lynas, maybe what's one other really high conviction play up your sleeve?

Victor Gomes: Well, I was actually going to use Lynas, but they put me on the spot now. Look, I'd say I was mentioning lithium before. And I do like Lynas because it's such a unique asset and you are having to take a three to five-year view on this. But management are fabulous, the asset is quite irreplaceable. And I think the opportunity to grow that into heavy railroads through what they're doing in the US gives them another leg of growth. And there's been some issues with Malaysia, but they're sorting that out.

Victor Gomes: But if I was to pick another one, since I'm sticking to that theme, I'd probably go with Pilbara, which I think is the last remaining asset available in this space. All the others have been taken out. Kidman got taken out by Wesfarmers. I'm not sure what they're going to do with that. Wagina is done. And it's now within Albemarle. And we don't know if that's going to work well because the plants being built. So here you have a tier-one asset, I think, long life, low cost. It's built, it's only stage one, but once you've proven up stage one, all you're doing is you're adding another whole bunch of kit that does exactly what the previous kid does. So you just cut and paste.

Victor Gomes: So it's got that Ben mentioned earlier that profile of growing production. Well, if the commodity price starts to work in their favour, lithium, and it is absolutely in the dumps at the moment. So if there's a contrarian view, that's one. It's well below the cost of production for most of these sectors. So it just feels like it can't get that much worse. And meanwhile, Pilbara washing their face at these prices. They've got the recoveries, they've got the plant working well, their balance sheet, they're going to refi their funding. They're paying 5% on their debt. So it's not distressed, the company's in a good shape, but it does require the commodity price to obviously move.

Vishal Teckchandani: Okay. Well, whichever way you cut it, there's plenty of value on offer in the commodity space. You just need to be willing to dig up for the highest grade opportunities and be a little bit patient.