Commodities | May 29 2014
-The four P's of mining investment
-Copper stands out in mining sector
-Ongoing opportunities in miners
-Financials versus resources
-Trimming an overweight call on miners
By Eva Brocklehurst
Morgans has good and bad news. Bad news is Australia's mining boom is over. Actually, the broker thinks it was over three years ago. The good news is that the bust looks to be over as well. The broker thinks the smart money is now playing the fundamentals, awaiting the next boom. What are the fundamentals? Now is the time, the broker believes, to enhance investment in the major miners and establish a position in moderately sized producers and developers. Morgans' guidelines include the four Ps of investing – People, Product, Profit and Prudence.
The people are the boards and executives who need to be able to deliver. The products investors should find easy to focus on are those that have a transparent and liquid market, such as precious and platinum group metals, and those base metals traded on the London Metal Exchange, such as copper, nickel, lead and zinc. Where there is no such transparency, such as with mineral sands, industrial minerals and graphite, investors should look at the contracted offtake agreements. Steel market bulks, iron ore and coking coal, remain a priority focus for the broker.
Copper stands out because of China's need to improve its air quality. This means electrification, which involves a lot of copper. The broker likes Finders Resources ((FND)) for its exposure to copper in Indonesia and thinks the company's expansion project is an opportunity to get in on the ground floor of a profitable copper producer. This leads to the third P, profit, as in profitable production. Mid-caps and juniors in a profitable position with strong balance sheets are preferred. Investors have traditionally also looked for those in the lowest cost quartile. These stocks need to have a reasonable mine life, around 7-8 years, to ensure a future of profitable production when the focus returns to the sector.
The broker likes the longer-term profiles of Perseus Mining ((PRU)) and Regis Resources ((RRL)), despite recent setbacks. Morgans also thinks Base Resources ((BSE)) and Orocobre ((ORE)) are travelling well but below the radar. Lastly, companies must be prudent with their debt servicing and hedging. The broker observes no sign of over-hedging at present, which can be disastrous if the company is short of committed product. Those companies which have comfortable levels of hedging and debt, while still generating significant cash flow, include Regis Resources and Beadell Resources ((BDR)).
Morgan Stanley prefers to be cyclical, not cynical, and finds ongoing opportunities among the diminishing returns in the mining sector. The broker emphasises asset quality and domestic assets and in this category the preferences include BHP Billiton ((BHP)), Fortescue Metals ((FMG)), Iluka Resources ((ILU)), OZ Minerals ((OZL)), Sandfire Resources ((SFR)), PanAust ((PNA)), Regis Resources and Whitehaven Coal ((WHC)). The broker believes large cap leverage still exists, as assets that have scale do not just survive but also increase competitive advantages. Morgan Stanley also favours quality, low-cost assets that are not leveraged to cost cutting through high cost production. The bulk exposures are kept in the portfolio, based on cash-flow growth, and this means Fortescue and BHP. Iluka Resources' asset quality and balance sheet allows the company to ride out the cycle, in Morgan Stanley's opinion.
JP Morgan has developed a market timing model that switches between the Australian financial and resources sectors. The model has returned 20.1% per annum over the last 20 years with annualised volatility of 20%, outperforming buy-and-hold strategies in either financials or resources. The broker currently recommends the defensive financials over resources. The reason the broker developed the model is that the banks and materials segments are two of the most important industries in the Australian equity market. They both average around 22% of the S&P/ASX 200 market capitalisation, but the relative weights have spread to 42% from 12% over the last 20 years. The model includes broader market sentiment signals and is used as a standalone model, or as a guide towards active industry weightings in a long-only portfolio.
The broker has also reviewed the case for being overweight on Australian mining stocks and notes iron ore plays have borne the brunt of selling. An overweight argument gives iron ore stocks a measure of protection, underpinned by the Chinese growth story, where there is limited downside because the government can, and will, back growth. Hence, there is also limited downside to the iron ore price. The third supportive factor is that stock valuations also have limited downside because they already imply lower iron ore prices.
Adding in the usual macro risks, JP Morgan accepts that the size of its overweight position in the sector looks too big relative to the level of confidence that is possible. The broker has become less convinced there is a case for a large buy-and-hold long position based on valuations and industry fundamentals. This suggests that a smaller tactical tilt may be required in the portfolio, rather than a high conviction Overweight call. Hence, as BHP's share price has weathered the pressure on the sector relatively well, the size of the overweight case is reduced by trimming BHP's weighting in the portfolio.
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