Thursday 15 November 2018

M&A could be an enema for crappy sector performance

Yesterday saw another significant M&A transaction being announced in the mining sector, with Pan American Silver acquiring Tahoe Resources.  This deal comes less than two months after the merger announcement between Barrick and Randgold, which was well received by the market.

Drain the Swamp!
I'd like to see a lot more of these deals announced because hopefully they will help clean up the mining sector and provide investors with some long overdue returns.  While the broader market has seen a tremendous bull market over the past decade, the mining sector has been stuck in a quagmire.  Not because of metal prices and not because of demand factors, but because the sector has done an extremely poor job of creating value.  In large part, this is because some companies or management teams have been exceptionally good at destroying value.  Public companies are supposed to make investors money and the mining sector has been atrocious in this regard.

Investors Chase Performance - No Love for Mining
Take a look at the 10-year charts below for Barrick, Randgold, Pan American, and Tahoe (all in USD).  Given the timing, going back ten years puts us at a pretty low starting point given the big market crash that took place in October 2008.  Yet, only Randgold and Pan American have seen their share prices increase.  Pan American is up, but holding that stock for the past ten years would have only generated you a measly 3.6% annualized return.  That is good relative performance, but weak absolute performance.  Only Randgold generated a good annualized return (12.3%) over that decade period, which is why investors are applauding the Barrick deal.

The mining sector is highly cyclical, so returns for investors need to be higher than the market to compensate for that risk.  Clearly, the opposite has been true.  If you had simply invested in the S&P 500 ten years ago (green line on the chart below) you would have had superior returns with a hell of a lot less volatility. 

Looking at these charts it is pretty evident why most investors these days don't care to invest in the mining sector.  Volatility is high and historical returns have been poor.

Mining Investment has Changed - Mining Brokers and Mining Funds are Disappearing
The poor sector performance also explains why the availability of capital has changed.  Retail brokers and portfolio managers are supposed to make money for their clients.  Most mining-centric brokers have blown up their books or have been shut down by their compliance departments.  On the institutional side, investors have pulled money out of mining funds to invest elsewhere and that has resulted in fewer mining funds with much less capital to invest.  Just look at the recent change in the $2.3 billion dollar Vanguard Precious Metals and Mining Fund, which is now called the Global Capital Cycles Fund.  Effectively, the change in strategy for this fund alone withdrew about $1 billion of capital from the mining sector.  Why?  Lower risk and volatility plus more consistent long-term performance.

I know I'm painting a gloomy picture here, especially for somebody who is supposed to be espousing the virtues of mining investment.  The reality is that buy-and-hold investment is a terrible approach in mining.  Vanguard is right that risk/volatility are high and long-term performance is poor or inconsistent.  The sector as a whole is poor at value creation, in part due to structural issues that result in the hyper cyclical nature of the mining industry.

Buy When They Cry, Sell When They Yell 
The beauty of the mining sector's cyclicality is that there are self-correcting forces at play, but it takes time for them to play out.  When capital is plentiful, mining companies will overbuild.  That causes prices to fall, resulting in mediocre financial performance and plummeting share prices.  Over time, inefficient mines will be shutdown and the sector will consolidate (like Pan American acquiring Tahoe).  Capital will be scarce, so few new projects will be built and that will eventually result in metal deficits.  And, voila, prices once again rise and the cycle starts all over again.

Due to the cyclical nature of mining, one investment strategy that can work well is a buy low, sell high strategy.  It's a simple concept; the challenge is in effective execution.  The best time to buy mining stocks is when the sector is deeply out of favour and the masses are selling.  You're not going to pick the bottom and initially you'll probably face steep losses if you buy too soon, but as long as you buy quality producers and quality assets the odds are high that you'll make attractive returns when the sector comes back into favour.  Just make sure you get out when the sector becomes hot and generalist money piles in, as that will be the time when mining management will once again overpay for mediocre assets and start destroying value.  Again, timing the top is tricky but as long as your timing is decent the potential for large returns is good. 

As a general rule, selling due to fear means the bottom will be lower than you'd rationally expect and buying due to greed (and ignorance) will mean that the top is likely going to be much higher than you'd rationally expect.  Buying mining stocks in late 2015 or early 2016 would have been very lucrative.  However, we still haven't seen a bull market in mining stocks, so selling positions in 2016 or 2017 would have been more profitable than continuing to hold them until now.

Nearing Bottom?
My sense at the moment is that we are close to an interim bottom in the mining sector.  Sentiment towards the sector is apathetic due to a combination of poor historical returns, the trade war between the US and China, and headwinds from the strong US dollar.  Valuations are becoming compelling and the economic outlook looks good for at least another year, driven by a very strong US economy.

As discussed above, I'm probably premature in my sense that the mining sector is at or near a bottom.  Often the true bottom is marked by a sharp down leg caused by capitulation selling.  Other times, the bottoming process is more gradual.  All I know for now is that it feels like we may be close to a bottom, so I have started buying large cap stocks in the mining sector.  As you will see below, I'm using historical data and my experience as a guide for what I'm buying.  (As always, this blog is for information purposes only.  Seek the advice of a broker and do your own due diligence.)

My Investment Narrative
First of all, I am heavily favoring base metal producers over precious metals producers.  Secondly, in the precious sector, I am favoring royalty companies and smaller producers over the senior producers in the precious metals.  Across the board, I'm trying to limit country risk and buying quality companies.  Buying quality doesn't help returns, as often marginal producers perform better on the upside, but it does protect my downside because these companies are less likely to implode if things take a turn for the worse.  Even if you lose the battle, live to fight another day!

Value in the Base Metals
Historical charts help explain my current investment rationale.  As can be seen below, the 10-year performance of base metal stocks is much better than for precious metals stocks.  A couple of the base metal miners, Lundin and Teck, have even outperformed the S&P 500 over the past decade. 

I've been buying shares of First Quantum and Lundin because I think copper prices will turn.  Fundamentals for copper are attractive at the moment, but that is not reflected by the price of copper.  Base metal prices have been depressed since the middle of the year due to the US trade war on China.  However, there are indications that China and the US may soon have productive trade discussions.  A resolution to the trade war would be very positive for copper, as well as other base metals like zinc.  But, even if copper prices remain stagnant, these companies offer compelling value at the current share prices.  First Quantum and Lundin are trading at about 0.7 times their NAV10% and Lundin is trading at a piddly EV/EBITDA of about 3.0.  There are risks around both companies (Panama and Zambia for First Quantum, acquisition risk for Lundin), but my sense is that those risks are fully baked in at the current price.  Teck also looks interesting, but I have a hard time buying that stock because of the heavy exposure to coal.

Side Note on Turquoise Hill
I've also taken a decent size position in Turquoise Hill because it just got too cheap to ignore, despite the hefty country risk that comes with Mongolia.  I have a suspicion that Rio Tinto will renegotiate the Oyu Tolgoi ("OT") deal with Mongolia in the next few months. 

The government of Mongolia owns 34% of the OT project, but it has been having a hard time funding its portion of capex and that results in interest bearing loans from Rio or its lenders.  The recent announcement that the $5 billion underground expansion of OT won't start until later than expected in 2020 likely means that the Mongolian government will have to pony up more cash or increase its loans.  I think it would make sense for all parties to replace Mongolia's 34% interest in the OT project with a higher royalty (currently 5%), which apparently has been discussed in the past (source).  As part of the renegotiation, Rio Tinto could clean up issues surrounding power sources for the mine, resolve a tax dispute, and replace the original agreement, which some believe involved some payola.  Most importantly, if Rio Tinto can pull this off it would also be an ideal time to take out the 49% of Turquoise Hill that it doesn't already own.  Even with a hefty premium, it would be paying an opportunistic price.  The last time Rio bought shares of Turquoise Hill, it paid around $20 per share!  It would be a blockbuster deal and bring luster to a crown jewel in Rio's portfolio.

Senior Golds - Meh!
The chart for precious metals stocks is just plain embarrassing.  Other than Newmont, which has performed in line with gold prices, gold miners have destroyed massive amounts of value.  Kinross takes the cake, with the shares down 79% over the past decade (remember that horrendous $7B acquisition of Red Back Mining???).

Given the terrible track record of most of the large gold producers, why would I want to pay over 1x NAV and over 6x EV/EBITDA when I can buy the better performing base metal producers for less?  No thanks!  I've never understood the cachet associated with gold miners.  In my opinion, they don't deserve to trade at premium valuations to base metals miners, who generally have been better corporate stewards, and they shouldn't be valued using a 5% discount rate (or, worse, 0% in some cases).

I'm not hot on gold at the moment because I don't see it performing well until the FOMC changes its stance on rate hikes in the US.  On sector sell offs, I'd buy royalty companies like Franco Nevada and Wheaton Precious before I buy a senior producer.  Royalty company valuations are considerably higher than producer valuations, but these stocks have performed well and are trading towards the low end of their historical valuation ranges.  I'd also consider buying smaller gold producers that get beaten down, as the senior golds will likely do more acquisitions as the sector turns.  No positions yet, but I'd put some on if valuations go lower.

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