It is hard to imagine an industry with worse headlines and prospects than the mining industry currently. But cycles inevitably turn, and when they do British multinational asset management company Schroders is betting that Anglo American is one of the global miners poised to make a good recovery.
In the past four years Anglo’s shares have fallen by 80% to R150 a share, a price last reached in February 2009 when the price dropped from R525.90 to R142.00 as markets around the world tanked.
As a recovery investor Schroders fund managers don’t get too swayed by the headlines, but instead focus on exploiting extreme mis-valuations in stocks.
“What you pay and not the growth you get is the biggest driver of future returns,” says Kevin Murphy, co-head of the Schroder Global Recovery Team who was presenting at the recent Morningstar Investment Conference in Cape Town.
Murphy runs the £685 million Schroders Recovery fund alongside Nick Kirrage. Over the past five years the Recovery Fund is up 79.6%, ahead of the FTSE All-Share, which returned 50.7%.
He explains, using the chart above, that whatever factors people may think will determine whether or not they make money from equity investments, the one thing that actually determines whether or not they do – again and again and again – has been the price they paid. It looks back over almost 100 years and simply asks, what is the correlation between the price one pays for assets and the returns one later sees from them?
“You could use almost any valuation metric here and see the same result – dividend yields, say, or standard price/earnings (PE) ratios,” says Murphy. “We prefer cyclically-adjusted PE ratios (CAPE). Standard PE ratios use forecast profits – also known as ‘guesses’ – while so-called ‘trailing’ PE ratios use only the most recent year’s profits.”
He adds that one year does not offer much of a guide as to whether or not a business has value, not compared with a decade’s worth of profit numbers divided by ten to reach a crude but powerful average, which is what cyclically-adjusted PE ratios provide.
Murphy points out that in December 1999 the FTSE was trading on 27.1 – in other words it was expensive.
At the time the market was highly polarised around new economy and old economy sectors. For instance Oil and Gas, Media, Telecoms and Technology were trading at all time highs of 35 plus. Financial services, healthcare, banks, real estate and general resources were also pricey, trading between 21 and 28.On the other side were those traditional companies that were not going to change the world: tobacco, which traded in a range of 7-14; and travel, utilities, chemicals, food and drug retailers, homebuilders and food and beverages, trading between 14 and 21.
Fast forward ten years to 2010 and tobacco returned 763%; and travel, utilities, chemicals, food and drug retailers, homebuilders and food and beverages returned 156%. The oil and gas, media, telecoms and tech sectors delivered a negative return of -46%.
“Polarisation is good news for stock pickers, but not for those who pick the market. If you had bought an ETF in 2000, you would not have done well because 30% of the market was in oil and gas and technology,” Murphy says.
Today if you had to group UK sectors by their cyclically adjusted PEs, you would find a different picture. The market as a whole is trading on 13.7 and within this banks look inexpensive with CAPE’s of between 0-7; basic resources, food and drug retailers, insurance, general retail and oil and gas companies trading between seven and 14 and technology the outlier on the other side, trading at 35 plus.
Keeping with their value philosophy Kerrige and Murphy bought into the very unloved banking sector in 2009 and troubled supermarket Tesco two years ago.
Most recently the fund has invested in Anglo American and Lonmin for good measure.
“Mining is a very cyclical industry and Anglo American’s current share price discounts a significant amount of bad news,” says Murphy. “Profits are very depressed – latest results reflected underlying EBIT of $1.9 billion, a 36% decrease due to sharply weaker commodity prices, and a far cry from the $9 billion earned in the company’s heyday.”
Two of the company’s five core divisions, platinum and coal are currently loss making. And ongoing cost over-runs in the $8.4-billion iron ore mine Minas-Rio in Brazil have dominated recent headlines.
While the company’s share price is back to its 2009 lows, the business is far more productive now. “Don’t look at the price, look at the valuation and with the shares trading at a sizeable discount to tangible book value, we feel that the rewards justify the risk. All it takes is a small bit of good news for a significant change in share price.”
On the positive side, Anglo has an attractive portfolio of assets, which should be able to generate significant value for shareholders over the long term.
While Anglo’s balance sheet is under some pressure, Murphy says the business is sufficiently financially strong to withstand further volatility in commodity prices. “It has $14 billion of debt on its balance sheet, but $23 billion of assets. That level of gearing is more than manageable for most businesses. The assets are good assets, global best in class assets and no bank would pull the plug.”
He says the dividend may be cut as a cash preservation measure in the short term (remember 2009?), but on a normalised basis, the current dividend level is sustainable.
In Anglo’s favour is a very strong management team. “If anyone can turn around the company’s fortunes, they can,” he says. “The point of a cyclical business is that it is cyclical – they can’t stay there forever.”
While Schroder is bulking up on the likes of Anglo, HSBC, Lonmin and Sainsbury, it is selling out of darlings like Unilever and British American Tobacco. “Great businesses that are trading at extreme valuations,” says Murphy.