Looking at fundamentals, we have begun to see signs of an improvement, notably in the mining sector, where leading indicators are turning upwards while valuations remain near multi-year lows. With commodity prices recovering, we should see an end to the two year earnings downgrade cycle for commodity producers.
Capital allocation – message received
For mining, we think the pick-up in M&A activity in the sector reflects improved confidence in the cycle and attractive valuations. Companies have got the message regarding more disciplined capital allocation and greater shareholder returns as evidenced in the most recent earnings updates.
Rio Tinto reiterated cuts to capital expenditure and raised the dividend by 15%; BHP Billiton announced $5bn cost savings and hinted at a share buyback later in the year; Glencore Xstrata announced additional synergies related to the Xstrata merger and also raised the dividend by 5%. It is this positive bottom-up momentum in the sector which has led to materials being one of the top performing equity market sectors over the first two months of the year.
As stock examples, we like Aurora Oil & Gas, which has done well on the news of a takeover bid for the company by Baytex, a Canadian oil & gas exploration and production company, and Reservoir Minerals, which is developing a joint venture with Freeport McMoran in Serbia.
Sentiment is overly negative
Earnings upgrades, based on improving fundamentals and commodity price increases could provide further momentum for the sector. Despite recent moves, valuations across the mining and energy space remain attractive, particularly at the small-cap end where no value is attached to potential exploration upside.
Looking more broadly at the surprisingly upbeat outlook for the resources sector, and its strong relative resilience in the recent market period, we could ask the question: “What on earth is going on?”.
Well, one simple explanation is that the resources sector had become oversold and that we have moved past the point of maximum pessimism. Fund manager allocations to the sector, as reported in industry surveys, had already reached record low levels by the end of last year and we have likely seen some short-covering of those positions. This has been most evident for gold equities, which endured a sustained sell-off in 2013 – down over 50% – but is now back up. Moving from pessimism to scepticism can have a powerful effect!
A contrarian bet
When we look at valuations relative to global equity markets we see that the sector has underperformed for three straight calendar years – the longest run since the early 1990s. Compared to the MSCI World Index, resource equities still look cheap.
Looking at our two largest holdings, Rio Tinto is currently on 9.7x this year’s earnings, while Freeport McMoran is on 11.4x.
At the small-cap end, energy and mining companies trade at a significant discount to their ‘proven & probable’ reserves, leaving investors with a free option on exploration activity. With such distressed valuations, it is unsurprising to see private equity investors sniffing around.
Such robust performance in a challenging market begs the question of how well the resource sector could perform in more benign macroeconomic conditions should they emerge this year.
