MINING: IS THE
CYCLE TURNING?

Mining companies are cyclical in nature, which means that in a perfect world, you want to own them when the cycle is in an upswing, while when the cycle turns negative you’d rather not own them. The chart below illustrates this by looking at Anglo American’s earnings in US dollars per share since 1999 and comparing this to its end-of-year share price, also in US dollar terms.

Anglo American earnings (US$/share)

The early 2000s saw the start of a commodity bull market in which China’s usage of commodities increased substantially. At the same time, investments in new mine capacity lagged, which led to soaring commodity prices and company profits. During the 2000s the mining companies used these profits to invest in new mine capacity to meet the ever-growing Chinese demand.

The cycle started its downturn early in the last decade, as China’s commodity usage growth started to wane and much of the extra capacity that the miners had spent their profits on came online (it takes time to build a new mine).

The cycle bottomed out at the end of 2015 and since then we’ve seen a steady recovery in company profits. However, commodity prices have now increased to levels last seen seven to 10 years ago. In fact, if spot prices persist, Anglo American is forecast to make almost US$8 per share in earnings for 2021. This has prompted some to argue that the current cycle is now reaching its peak, and that it’s time to sell out and run for the hills, especially against the backdrop of a still uncertain global economy following the outbreak of the COVID-19 pandemic.

CAPITAL DISCIPLINE

Unfortunately, we don’t live in a perfect world and we don’t know exactly when the cycle will turn against the miners. What we can do, however, is evaluate the current cycle against those of the past to look for clues as to how this one may play out.

One of the key features of the current cycle has been the extent to which the miners have exercised capital discipline by not overinvesting in new projects. To illustrate this, during the latter stages of the last bull market, virtually all of the ~US$40 billion per annum cash flow from operations made by the large diversified miners went into spending on new or existing mines. Today, the operating cash flow has recovered to the levels last seen during those boom years, but only about half of the total amount across the industry is being invested into new or existing mines, the excess being returned to shareholders. The lack of meaningful investment means that, in the case of most commodities, there is not massive new capacity coming online that is likely to bring the current cycle to a sudden end.

What about the demand side of the equation? In the year before the COVID-19 pandemic, we argued that the global economic cycle was in all likelihood at an advanced stage and that risks were starting to build to the downside. We therefore reduced our cyclical exposure to the miners despite remaining positive on the counters themselves. Of course, no one could predict a global pandemic, but this did result in a global recession and a sell-off in commodity shares to levels where we thought them attractive enough to add to them again.

Since then, we’ve seen a China-led recovery in demand for most metals and a later recovery in energy on the back of positive vaccine news. While uncertainties remain, we’re of the view that the vaccine roll-out will in all likelihood be successful over the next few years and that global economic activity should respond positively, which in turn is likely to be favourable for commodity demand.

IMPLICATIONS FOR PORTFOLIOS

The other striking feature of the current cycle has been the extent to which companies have been valued quite rationally by the market. In fact, in our assessment, the market has already more than factored in high spot prices to correct to what we believe to be fair longer-term prices. This implies that the companies are not excessively priced by the market, and that the longer spot prices remain high, the more company earnings will be upgraded and dividends increased, leading to better-than-expected shareholder returns.

To illustrate this, consider again the Anglo American chart above. The current share price is ~US$38, still far below its 2011 level of over US$50. But at the same time, earnings at spot commodity prices are estimated at close to US$8 per share, far exceeding even the 2011 high of US$5.1. The longer spot prices remain high, the more earnings upgrades from the current consensus estimate of US$4.4 per share we’re likely to see.

Having said this, we’re cognisant of the fact that in the past, high prices have been followed by low prices, as sustained high prices may lead to either demand destruction or supply additions. But while we’re keeping a close eye on developments, we believe it’s too early to run for the hills just yet.