By Daniel Sacks and Hanré Rossouw*
Daniel and Hanré, portfolio managers of the Investec Commodity Fund explain why they see value in the resources sector and how the sector will recover.
For the past five years, the JSE resources sector has underperformed the broad market, to such an extent that all relative gains from the commodity super-cycle have been erased (as can be seen below). The sector again appears to be extremely undervalued compared to the rest of the market, leading many investors to ask whether this is the time to invest mining companies.
Sector performance relative to the FTSE/JSE All Share Index since 1960
 
Source: I-Net Bridge, as at 17 April 2015
We believe there is opportunity in the sector at the moment, as we calculate value in several mining companies with dividend and free cash-flow yield estimates at attractive levels – despite our conservative margin forecasts. We expect the sector to recover from cyclical lows through a combination of commodity prices performing above (very bearish) expectations and improving company cost structures. Potential economic stimulus could also bolster performance in the near term.
Underestimated earnings, surprises to come
The management of many mining companies have started running their businesses for an environment of lower commodity prices and subsequently reduced operational and non-operational costs. Indeed, recent results for mining companies have in many instances reported falling dollar unit costs. These have been achieved thanks to much weaker producer currencies (such as the rand and Australian dollar), declining energy costs, and higher grades of product mined, as well as labour efficiencies and cost containment.
At the same time, we think that consensus expectations for commodity prices are approaching the ‘last downgrade’. Spot commodity prices are at times above what the market is expecting for future prices – a phenomenon which we have not witnessed for many years. Importantly, spot prices are also below the marginal cost of production for most commodities. The net result is typically that mining companies will continue to restructure their portfolios while spot prices prevail and very few new projects will be approved. This will likely result in more balanced or even undersupplied markets, which we believe should support a recovery in commodity prices.
Mining shares discount the market’s view of future profitability. We believe that the current share prices of many mining companies underestimate the earnings that will be generated, with surprises coming both on the cost and revenue side. Mining shares should therefore outperform as forward earnings expectations are revised upwards in line with our expectations – all in the absence of a resumption of the super-cycle.
We prefer base over bulk
We continue to favour base metals, which feed more into consumer products, over bulk materials such as iron ore and coal that are predominantly used in the construction and power sectors. A significant new supply of iron ore from the major companies is now hitting the market, adding to the woes of the industry.  Although we expect the oil price to recover towards the end of the year, this has largely been discounted by the equity market. The anticipated upturn is also reflected in the forward curve of the oil price, which remains higher than the current spot price. We expect the gold price to remain robust as the US Federal Reserve (Fed) will likely continue to err on the side of caution when it comes to the pace of rate hikes.
Platinum: market too optimistic about recovery
Although the platinum price is expected to strengthen to a level where it is again trading at a premium to the gold price, we believe the equity market is still too optimistic. It is factoring in a much stronger recovery than is likely, given the significant above-ground stocks of platinum that have accumulated in recent years.
We thus expect to see a continued divergence in the performance of resource stocks for the rest of the year. With profit margins at cyclical lows, changes in commodity prices should continue to significantly impact profitability. In our view, management’s ability to respond to the challenging environment through cost-cutting and efficiency improvements will also be a differentiating factor. Some miners should still be able to grow free cash flow and dividends, despite the headwind of falling commodity prices.
Time to increase exposure
We believe there is an argument to be made for commodity prices improving in excess of our moderate view: China easing monetary policy to stimulate growth could be a key factor. At the same time, lower US job growth or even unemployment (due to the shale oil capital expenditure cuts) along with muted inflationary pressure, could result in the Fed changing its language to be more accommodative. If it does, then commodities should go up as the US dollar falls. On average, most funds are currently significantly underweight commodities. If the market turns, there may be a scramble to increase exposure to commodities. Why wait? We believe it might be time to increase exposure to the mining sector.
*Daniel Sacks and Hanré Rossouw are portfolio managers of the Investec Commodity Fund, which received a Raging Bull Award for the Best SA Equity Resources Fund in January this year. Details of the award are available from the manager.Â
