The mining sector has endured a bumpy ride as of late, with a catalogue of unfavourable factors threatening to provide significant headwinds.
Indonesia’s ban on exporting ore in January 2014; tougher Chinese pollution regulations resulting in quarterly coal imports plummeting 42% a year later; Chile’s announcement of a $30bn cut to its mining investments over the next decade; uncertainty plaguing the South African industry stemming from a lack of definitive regulations – nothing indicates that life is going to get any easier for the global resource trade.
But on top of the aforementioned stumbling blocks, it appears that there is yet another reason the investor community is distrustful of the sector.
“Mining companies are run by the kind of men that you would not want your daughter to bring home,” said Tim Steer, manager of the Artemis UK Growth Fund.
While Steer holds a 7.3% weighting in basic materials, he makes clear that none of this is geared towards miners.
“I do not do mining,” he said. “You can get hit by regime changes in certain parts of the world or faulty mining reports. Frankly, it is an insider market – as an investor you need to know what is happening on the ground, and I am not going to travel to Ghana to know what is going on.”
While on the surface miners continue to generate what appears to be healthy revenue streams, Paul Stephany, manager of Newton Investment Management’s UK Opportunities Fund, believes that if you bore down into company fundamentals it is a very different story.
“Mining companies are the antithesis of everything I invest in,” he said.
“In any mining company, the person who controls output prices is completely separate from headquarters. The boards have no power over the price of what they will be selling five years down the line when they are making investment decisions, such as whether to build another mine. That is the key problem, and why cash flow figures are so worrying.
Stephany cited firm’s unwillingness to reinvest their proceeds and focusing instead on earnings generation as the overriding factor in he believes the industry outlook is decisively bleak.
“Capital expenditure is such a huge proportion of the cash that mining companies generate, so how they spend it is absolutely critical,” he explained.
“In addition, assets are dwindling. The whole time that they are not investing, their assets are running out. Even in a pretty good stage of the cycle, they are paying minimal dividends out.”
To emphasis his point – which is illustrated in his portfolio by a 7% underweight to the sector – Stephany referred to Anglo American’s profit and loss statement for 2014.
“Bringing $27.1bn in revenue down to $5.2bn, taking tax off and then putting a market multiple on earnings – you could say that $5.2bn looks good,” he expanded.
“But that is neglecting the importance of depreciation in cash flow, what is required to get CAPEX to stand still and thinking about the asset life. According to Anglo American’s accounts it costs $2bn a year to keep their assets at a standstill and even more to grow.
While the figures are those of just one company, Stephany believes they are indicative of a wider sector issue as global consumption rises and miners are forced to go further afield in search of assets.
“In Anglo American, I have given you the worst example,” he said. “But the problem is the same for across resources companies.
“As the years go on resources are getting harder to mine. The CAPEX that you need to put in for the same amount of output is going up, which is a real drag on profits. Also, you are going to go deeper and deeper into more remote areas such as Africa, where there is no infrastructure so you need to build a full port and railway. As a result you have just pulled the plug on some of those assets, and when it comes down to the cash conversion line and there is less nothing left to pay dividends.
“As a result, when these companies pay dividends their debt increases, and when the next cycle comes – with a halving of the iron ore price, in the most recent case – the business is less resilient than it was before. Even in the good times it does not generate much cash, and in the bad times it haemorrhages cash. There is no capacity to pay dividends, the companies gear-up rather than de-gear, and there is certainly nothing left for acquisitions.”
But rather than working to reverse the problem, Stephany says, mining firms are persisting with counterproductive practices and exacerbating negative long-term implications.
“All this time the management is getting the market plaudits for growing the earnings number, but they are not generating any cash,” he explained.
“The earnings versus cash dichotomy is very important, and investors should not believe the hype when it comes to management changes in the mining sector. They all suffer from the same problem as any CEO in a resources business – under pressure to grow and pay dividend, but hamstring by the growing cost of extraction.”
