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Are we there yet (again)?

Timing the market is no easy feat.

Our businesses have been adversely affected by the combined effects of lower commodity prices and the impact of the financial situation in Asia. Difficulties in bringing some important capital projects on-line have also impacted on our results. In response to these challenges, BHP is making changes needed to become a stronger, more competitive company that is able to deliver greater value to shareholders. Key elements include driving costs down and reshaping our asset portfolio. Our efforts in these two areas are gaining momentum with very encouraging results being achieved in many of our businesses…

…Putting the year in perspective BHP, like many other companies, is in the midst of fundamental change. The motivation for this change is increasing shareholder value. This means a leaner, more competitive Company that deals with capital allocation rigorously, and takes account of risk and its management and our environmental and community responsibilities. The test of these changes at BHP will be improved value for shareholders.’

BHP Chairman’s Letter, 1998 Annual Report

‘We remain alert for a major opportunity, and our mergers and acquisitions group has been busy during the past year. To date, the Executive Committee has judged that various opportunities put forward for approval would become more attractive with the passage of time. This judgment has so far proved sound, as deteriorating commodity and financial markets have progressively depressed the values of mining assets. Billiton, its financial resources intact at this low point in the commodity cycle, is well placed to profit from these circumstances…

…in June 1998, we announced our intention to seek approval from shareholders to repurchase up to 10% of the issued share capital. At the current depressed share price, a repurchase would create a more efficient capital structure for the Group, with a resultant lower cost of capital, and would enhance both earnings per share and net assets per share.’

Billiton Chairman’s Review, 1998 Annual Report

‘Global demand for our products was, therefore, broadly maintained. But increases in mining industry capacity combined with regional economic instability to cause the lowest prices we have seen for many years in several of our products. Efficiency is more than ever the key to countering inevitable market fluctuations and to meeting shareholders’ expectations…

There is no doubt that 1999 will be another difficult year. Overall global demand for Rio Tinto’s products is likely to be constrained and insufficient to absorb increases in mining output, at least in the short term. There is no immediate prospect of commodity prices recovering, although the turnaround, when it comes, usually occurs rapidly. Many producers are incurring cash losses at current prices and some closure of capacity looks inevitable. We will also see sharp cuts in industry exploration expenditure. These factors, together with renewed economic growth and demand, will eventually restore more profitable conditions.’

Rio Tinto Chairman’s Letter, 1998 Annual Report
‘In the current environment, it’s clear why a strong balance sheet and cash generation are a necessity rather than a luxury. Signs of recovery in industrial demand are yet to emerge and a prolonged downturn brings increased risk…

For some time, we’ve been highlighting the iron ore exits. At the start of 2015, we anticipated cuts for the year around 85 million tonnes. We actually saw 130 million tonnes cut from the high-cost production. This was on top of the 125 million tonnes of exits that occurred in 2014. So high cost supply is leaving the market.’

Sam Walsh, Rio Tinto Chief Executive Officer, Rio Tinto 2015 Full Year Earnings Call
In REVIEW Volume 6 of October 2008, we published an article entitled ‘Are we there yet?’. This piece set out to gauge whether we were approaching a bottom in equity markets, which were falling precipitously at the time. Given the maelstrom engulfing the mining sector in recent months, the extent of the share price declines in the sector, and RECM funds’ exposure to the sector, we thought it would be apposite to write a follow up to our original article, but this time focused exclusively on the mining sector.

As Chart 1 below shows, global mining shares hit multi-year lows in price terms, and multi-decade lows in valuation terms, on 1 September 1998. This presented a generational buying opportunity.

Chart 1: Thomson Reuters Datastream World General Mining Index (log scale)

Source: Thomson Reuters Datastream

The first three extracts quoted in the opening lines of this article were written in a six-month period (BHP and Billiton had June year ends, Rio Tinto’s is December) from about September 1998 until about March 1999. The picture painted in these remarks bears such striking similarity to the one the mining industry faces today (as the quoted text from Sam Walsh illustrates) that we were tempted to let Occam’s razor loose on this article and conclude that yes, we have indeed hit the bottom in the mining sector. But much as we admire simplicity, we’re also mindful of the danger of a ‘neat, plausible and wrong’ conclusion to a complex question (to paraphrase satirist H.L. Mencken). So let’s revisit the factors we evaluated in our article more than seven years ago, as well as a few additional ones, and attempt to shed some light on the question of whether we’ve indeed hit the bottom in the mining sector.

First, a caveat though. Attempting to ‘call the bottom’ in a market is much the same as trying to time markets. The extent of our ‘timing’ of purchases and sales of assets essentially goes so far as to buy them when they’re priced at a discount to fair value and sell them when the discount contracts or fair value is reached. Price to value, quality, cyclicality and popularity remain our primary guiding lights when constructing portfolios. Assessments like the one we’re making in this article merely serve as circumstantial evidence giving us some indication of whether our sense of price to value relationships are directionally correct or not.

To illustrate the point: our original article concluded that markets hadn’t yet hit bottom. Very little changed in the indicators of a bottom we were looking at between the date our article was published (late 2008) and early 2009 (when global markets actually bottomed) except that share prices moved down about 20%. The fact that all indicators of a market bottom having been reached didn’t flash green yet at the time, did not prevent us from reaching the most fully invested position ever in our flexible funds in early 2009. Do keep this in mind when reading the rest of this article and our conclusions below.
The eight metrics of our original article revisited in the context of the mining sector

1. Public apathy and low volumes
The travails of the mining sector have been receiving wide media attention – hardly indicative of public apathy towards the sector. But interestingly, share trading volumes have been very low (similar to levels seen in the late 1990s and early 2000s) for the last two or three years, before picking up sharply in the last few months, as Chart 2 illustrates.

Chart 2: 12-Month Moving Average of Daily Number of Shares Traded

Source: Thomson Reuters Datastream

2. Investment horizons contract
At the height of the commodity supercycle, the only focus of mining companies (and investors) was the size of future growth projects stretching years into the future. This was typified by the so-called ‘bubble charts’, indicating the billions of dollars of projects in pipelines and expansion options. Today, the focus has shifted 180 degrees to cash flow generation and the ability to meet debt repayments in the next year.

By way of example: two of the key highlights pointed out in the very first slide of Anglo American’s 2010 full year results presentation was the expected 50% growth in production volumes for the next five years, and the $70 billion project pipeline with the potential to double production over the next decade. In Anglo American’s 2015 results presentation, the four points on the first slide point out how the group is shrinking to a core portfolio of assets, that the group will be free cash flow positive in the year to come, that assets outside of the core portfolio are being managed for cash or disposal, and that net debt will be substantially reduced by the next year end. Not a single word about any expansion project or any timeline beyond one year.

3. Delisting of good companies suffering from poor price performance
There have been some instances of delistings from the London market, but these have typically not been companies owning prized assets, and have also had some political motivations behind them. Companies coming to mind here include ENRC, Bumi Resources and Uralkali. The distinct impression we have is that the sentiments expressed in the 1998 Billiton Chairman’s Review are shared by most companies in the mining sector today, which is holding back even the strong players in the industry from stepping up to buy out rivals owning good assets.

If we consider ‘delisting’ to include wider consolidation transactions, the evidence is still lacking. In fact the trend to date in this latest down cycle has been for companies to split off assets (e.g. BHP Billiton spinning off most of the legacy Billiton assets into South32, Alcoa announcing a separation of the group into an upstream and a downstream focused business), rather than for companies to bulk up by acquiring weak competitors.

Reading through the large diversified miners’ annual reports from the late 1990s and early 2000s, it’s clear that strong players in the industry were buying up assets and consolidating global mining assets at attractive prices. In some sectors of the mining industry (platinum being a prime example, with Sibanye’s recent actions to buy assets and create a large new group in the platinum market) we’ve seen the consolidation moves, but by and large it seems that the strong players have been watching from the sidelines. Perhaps Anglo American’s recently announced large scale portfolio restructuring will be the trigger for the type of consolidation transactions that we saw when Billiton pounced on BHP in 2001. At the time BHP was still to find its proper footing again after a period of recovering from expensive acquisitions and projects that went wrong which left the company with an almost unmanageable debt load. The similarities to the position that Anglo American finds itself in today are strong and striking.

4. Investment banks scaling back or closing their businesses
Check. Investment banks have been closing commodity trading desks and selling off assets (warehouses and the like) in the metals industry at a rapid rate. An internet search for ‘investment bank closing commodity business’ brings up a host of articles about almost every major investment bank (Morgan Stanley, Barclays, Credit Suisse, JP Morgan, UBS, Deutsche, Jefferies, Standard Bank and the list goes on) closing or scaling down their involvement in the industry.

Related to this is a plethora of commodity and/or mining focused investment and hedge funds shutting their doors. Funds from some of the world’s leading investment firms that held assets in the billions of dollars only two or three years ago have dwindled down to tens of millions of dollars in recent months, before being shuttered. The asset base of the most prominent fund in the mining sector, the Blackrock World Mining Fund, has collapsed from $17.9 billion in May 2011 to only $2.8 billion today.

5. Business failures
There have been a number of business failures in the mining industry, specifically in coal mining and in iron ore. Some US coal miners sporting multi-billion dollar market caps only a few years ago (Arch Coal, Peabody Energy, Patriot Coal, Walter Energy, Alpha Natural Resources) have declared bankruptcy in the past year. Major Indonesian coal miner Bumi Resources, which listed amid great fanfare and excitement in 2010 after coal prices had recovered strongly from the global financial crisis lows and helped along by the involvement of the scion of an illustrious family in European finance, has since also engaged in debt restructurings.

While the large iron ore miners (even the heavily indebted ones like Fortescue Metals) have so far managed to avoid the dramatic fate of the US coal miners, a number of smaller iron ore miners with more marginal projects have had to shut their doors. A similar situation has developed in markets like aluminium and nickel.

6. ’Cash is king’
As the comments in point two above made abundantly clear, this is undoubtedly the mantra of the moment in the mining industry.

7. Markets don’t sell off on bad news
Mining shares have been so volatile of late that it’s difficult to make an accurate assessment of this marker. But an example of this phenomenon of share prices not selling off on the announcement of bad news very recently is when Anglo American’s share price went up on the day that Moody’s announced a ratings downgrade. In recent months though, we’ve seen some prodigious share price increases in the sector on no positive news at all, which is probably the functional equivalent of share prices not falling on negative news!

8. Forced sellers
Of the major diversified miners, Glencore and Anglo American have become forced sellers of assets to cut debt levels. While it won’t be their most prized assets going on the block, it will certainly be good assets in the context of the broader mining sector. A number of commodity traders have also started selling the upstream businesses which were so eagerly acquired when ‘securing access to the resource’ was considered to be of prime importance to the trading businesses.

While we can probably not say that all eight boxes above have been emphatically ticked, those that don’t get a full tick mark (probably numbers one, three and five) must get at least half a mark. Six and a half out of eight isn’t a bad score in any test!
A further set of factors we consider as indicators of a market bottom

In addition to the eight indicators of a bottom we investigated in our original article seven years ago, a few more come to mind as useful indicators of the conditions surrounding a bottom in the mining sector. Here they are:

1. Dividend cuts and capital raises
All of the major diversified miners have announced material dividend cuts. While both Anglo American and Rio Tinto cut their dividends in the 2009 global financial crisis, this is the first time since 1988 that BHP is cutting its dividend.

On the capital raising front, we’ve seen Glencore raising equity to assuage market concerns around its debt levels. The other diversified miners have avoided capital raises thus far, but in selected subsectors of the mining industry we’ve seen material capital raises (e.g. Lonmin in the platinum industry).

2. Real metal prices
While the inflation adjusted price picture varies somewhat across the spectrum of metals, copper and iron ore are probably the two most important metals for the diversified miners as a group. Chart 3 below shows real copper and iron ore prices since 1900.

Chart 3: Inflation-Adjusted Copper and Iron Ore Prices Since 1900

Source: Thomson Reuters Datastream, Grilli & Yang, USGS, RECM

Both copper and iron ore prices have declined dramatically in the last few years, and at current prices (about $4,500 and about $45 per ton for copper and iron ore respectively) are about 20% to 25% below their long term average real prices. But these levels are still some way above the inflation adjusted levels we saw in the prices of these commodities in the major historical bottoms.

3. Profit margins
As investors tend to extrapolate the recent past in markets into the distant future, a low point in profit margins typically point to investor expectations being low and prices consequently being at low levels in a sector. Cash profit margins (earnings before interest, taxes depreciation and amortisation – ‘EBITDA’) in the mining sector have been decimated of late, as Chart 4 below shows, and are now at levels commensurate with the lowest in the past thirty years.

Chart 4: Thomson Reuters Datastream World General Mining Index EBITDA Profit Margins

Source: Thomson Reuters Datastream, RECM

4. Capital expenditure cuts
This is happening on a large scale – but is coming off an extended period of very high levels, as Chart 5 shows.

Chart 5: Thomson Reuters Datastream World General Mining Index Capital Expenditure Relative to Total Assets

Source: Thomson Reuters Datastream, RECM

If capital expenditure cuts actually proceed as announced, the chances are fairly good that we’ll be reaching historically low levels of capital expenditure relative to total assets quite soon. By way of example, BHP Billiton has indicated that it will be cutting capital expenditure by about two thirds from the peak levels reached in its 2013 financial year.

5. Merger and acquisition activity levels
This is somewhat related to point three of our original eight factors we evaluated, but the emphasis here is more on the level of overall corporate activity than on smart money buying good assets on the cheap. Company management teams and boards of directors are human too, and often get carried away by the same groundswell of optimism about their own business or industry that drives market prices of assets beyond fair values. As a result, one typically sees merger and acquisition activity increase substantially in the run up to a market peak, and fall off sharply as the market heads downward. This pattern has indeed been evident in the mining sector, with the value of deals, in particular, recently dropping to levels seen in the late 1990s.

Chart 6: Volume and Value of Mining Deals in Relation to Share Price Levels

Source: Thomson Reuters Datastream Eikon, RECM

On our additional five metrics, the evidence today is mixed. While some indicators of a bottom are clearly there (dividend cuts, profit margins at very low levels, the value of merger and acquisition activity falling to very low levels), on others the evidence is yet to emerge (e.g. major capital raises, real metal prices to hit historically low levels).

Lessons from the history of bear markets
In 2005 market analyst and historian Russell Napier published a very interesting book entitled ‘Anatomy of the Bear’. This book analysed the conditions surrounding the four great bear market bottoms that the US stock market had seen in the preceding century, namely in 1921, 1932, 1949 and 1982. His observations were prescient, and served as a useful guide in assisting investors to navigate the 2008 bear market and 2009 market bottom that ensued not long after publication of the book. While all factors associated with bear market bottoms don’t relate directly to an individual sector (as opposed to the stock market as a whole), we highlight a few factors and their current status in relation to the mining sector below, to the extent that they weren’t already covered in the points we’ve raised above.

1. Long term valuation measures like cyclically adjusted Price-to-earnings ratios and Price-to-replacement-cost ratios reach historically low levels.
While price to replacement cost isn’t directly measurable for the mining sector with the data we have at our disposal, we can attempt an approximation. The price to replacement cost for the broad US market has historically been very closely correlated to Price-to-book ratios. Applying this measure to the mining sector shows that both the Price-to-ten-year-average-earnings ratio and the Price-to-book ratio of the global mining index have reached thirty year low levels of late.

Chart 7: Thomson Reuters World General Mining Index Valuation Multiples

Source: Thomson Reuters Datastream

2. The market became cheap slowly, taking on average nine years from peak levels to hitting bottom.
From the peak reached in mid-2008, we’re now seven and a half years into the mining bear market (there could be some debate about whether to start measuring from 2008 or the subsequent high point in the sector reached in 2011, but the absolute high of the index was reached in 2008, not 2011). This is shorter than the duration of the average bear market that historically resulted in a market bottom, so we may have to wait some time yet in the mining sector.

3. An increasing supply of good news is ignored
While this point is a bit of a contradiction to our original point seven above, it has been difficult to find much good news in the sector of late. But we’ve definitely seen matters like news of capacity cuts in some industries (aluminium, steel, coal) being met with a great deal of scepticism and commentary to the effect that ‘the capacity will just come back to the market at the first sign of an uptick in price’. While these comments are valid, it may just be a classic case of the good news (i.e. market balances being restored) being ignored at the bottom of the cycle.

4. The decline in corporate earnings continues well past the bottom in the stock market
This is an important point to highlight: the market doesn’t bottom when earnings bottom. The market bottoms before reported earnings bottoms. So we don’t need earnings to start recovering for a bottom in the mining sector to be reached. Whilst it’s true that traditional valuation measures like Price-to-earnings, dividend yield and Price-to-book value have been worse predictors of future five- to ten-year returns from investing in the mining sector than they’ve been for the market in general, today we find close to all time high dividend yields in the sector being derided as being illusory because of the dividend cuts that are about to happen.

Yes, dividend cuts have been happening and will happen, and the double digit historical dividend yield on some mining shares isn’t the dividend yield you’ll receive in the next year if you buy the stock today. But such extreme valuation multiple levels (the historical dividend yield on the Thomson Reuters Datastream World General Mining Index has recently been in the vicinity of 8%, a level which has only ever been eclipsed for the briefest of moments in late 1974 in the past 35 years) point to conditions of low valuation relative to longer term fundamental values in general. The fact that the multiple may increase or the dividend yield may decrease when the next earnings or dividend announcement is made isn’t the critically important factor. The critically important factor is that the extreme historical multiples point to conditions in which the market tend to misprice assets.

5. The end of a bear market is characterised by a slump of prices on low trading volumes. Rising volumes at higher price levels after the first rebound in equity prices signals that the bear market is over.
While the slump in mining share prices over the past two or three years has indeed been happening on fairly low trading volumes (refer to Chart 2 above), the implosion during 2015 has been occurring on rising trading volumes – which seems incongruent with a bear market bottom being reached. But, on the other hand, in the very recent past, sharp share price increases in the sector have been occurring on rapidly increasing trading volumes, which, if it persists, may in fact point to a bottom having been reached.

6. Short positions reach high levels at the bottom of the market and increase in the first few weeks of the bull market
While the history is short and the data we have somewhat incomplete, it does appear that short interest in the miners have indeed reached very high levels in recent months – specifically in the stocks that have experienced the worst share price declines during 2015 (Anglo American and Glencore). And it also seems that short interest has been rising in the face of the sharp rally in some mining shares we’ve seen over the past two months – which is very much in keeping with the pattern pointed out by Russell Napier in his book.

On these six factors taken from ‘Anatomy of the Bear’, the evidence is again mixed, but the score probably tallies to something like four or four and a half out of six. A passing grade, but certainly not a convincing result.

So, what is our conclusion then, having looked at all the factors and indicators we have? As always in markets and investing, the evidence is mixed, and one’s conclusions on a number of the factors considered can be as much a matter of judgement as of fact. But on a balance of probabilities, our scoring suggests that we’re indeed experiencing conditions in the mining sector which, if not associated with the very bottom of the market, are at least associated with conditions not too far from the bottom of the market.

Keep in mind that the fact that a bear market bottom has been reached (if indeed it has been reached) doesn’t necessarily mean that prices will rise quickly from the bottom (although that has often been the experience in the mining sector in the past). A recovery may be slow and gradual. Be that as it may, the past five years have been a disaster for investors in the mining sector. We dare to say that the next five years may look very different for those who stay the course.

Wilhelm Hertzog is an analyst and portfolio manager at RECM.


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