We are often asked on what basis we invest in resource companies
Mining shares were one of the few places to hide in 2018, offering the only double-digit returns in the FTSE/JSE Top 40 Index, which was down overall. Yet we have been reducing exposure to this sector, with mining shares now comprising less than 8% of the PSG Equity Fund compared to 14% early in 2016. Our most recent sale was Anglo American Platinum (Amplats), which we exited entirely earlier this year, having held it since 2017. It serves as a useful case study of how we think about investing in the sector.
Commodity producers are price takers, which means their profits are less predictable
Generally, companies that produce commodities have no say on the price realised for their output. Accordingly, their profits are largely dependent on global economic factors and the range of possible outcomes is wide. In terms of our 3 M (Moat, Management and Margin of Safety) analysis, these companies have narrow moats and therefore cannot be relied on to grow profits ahead of the market over long periods. We call such businesses ‘mean-reverters’, and our investment decisions relating to these businesses must factor in the unpredictability of future profit streams.
Mining company management teams have on average proven to be poor allocators of capital over the cycle
Management teams in the resource sector have generally shown a tendency to build mines and buy competitors when prices are high, and to sit on their hands when prices are low. This pro-cyclical capital allocation has tempered shareholder returns over the past decade-and-a-half – a period of booming commodity prices and rapid growth in demand from China. A canny management team can make a big difference in this sector, so we pay careful attention to the team that will be acting as fellow custodians of our clients’ capital.
To make provision for these risks, we focus on ensuring a sufficient margin of safety
Given the narrow moat, we place increased emphasis on valuation (margin of safety) when we consider investing in a commodity producer. Since macroeconomic data – and particularly future demand – is unpredictable, we do not attempt to forecast commodity prices. Instead, our work is focused on the supply side of any given commodity. This entails understanding the long-term capital cycle for a commodity and what it suggests for the sustainability of prices, whether high or low.
A recent example is the collapse in commodity prices and mining shares in 2015/2016. After many years of booming capital expenditure between 2007 and 2012, prices slumped as supply flooded a market in which growth was declining from very high levels. At the peak of the 2015/2016 crash, it was evident that the prices of most commodities were well below the levels required to incentivise additional capacity. Capital expenditure plans were slashed and some mines were being mothballed. It was clear to us that prices were unsustainably low. We find it much easier to build evidence that a resource company is trading at a significant discount to our assessment of its intrinsic value (i.e. offers a margin of safety) when commodity prices are depressed. As a result, our funds invested in mining shares at the time, including Anglo American, Glencore and Merafe.
Amplats as a case study: evaluating its Moat, Management and Margin of Safety
When we analyse mining companies, we pay particular attention to their relative position on the cost curve and how this is likely to change. A low-cost producer is much more insulated in an industry that undergoes boom-bust cycles. Amplats has a significant competitive cost advantage due to best-in-class ore bodies that allow for efficient and low-risk access, mechanised extraction methods, and well-designed downstream refining assets. It is further insulated by having the most diversified basket of metals among its competitors (platinum comprises less than 50% of its production) and by the industrial-like processing agreements it recently established with its peers.
A quality segmentation of the mining assets in the platinum group metals (PGM) industry reveals that the gap in profitability between the front-footed and more marginal producers is likely to continue widening. Only a few management teams – enabled by the quality of their assets – have proactively redesigned their businesses to lower risk and ensure profitability in a persistently weak metal price environment. An assessment of Amplats’ management and their capital allocation decisions shows that they started taking steps to improve the quality of the company’s earnings and balance sheet as far back as 2012. Though many of their decisions were unpopular at the time, they’ve steered the company away from exposure to narrow, steep and labour-intensive ore bodies towards higher-quality assets. In doing so, they have also reinvested in the company’s moat. Completed in 2017, this shift has enabled Amplats to grow returns and maximise free cash flow in an environment where many of its competitors still face marginal returns and the prospect of restructuring.
Margin of Safety
At the time of our initial investment in the first quarter of 2017, Amplats’ PGM basket price (in rands) traded at depressed levels. This was due to an oversupply in platinum, as well as poor market sentiment driven by the unsupportive economic environment for the metal. (Concerns included European light-duty diesel vehicle market share declines, the rise of battery electric vehicles, and lacklustre Chinese jewellery demand.) Accordingly, our funds could invest in the company at a significant discount to our conservative estimate of intrinsic value (in other words, with a sufficient margin of safety).
Amplats proved to be a successful investment for our clients
The share price appreciated by 180% over the period our funds were invested (and 145% in the final year they held the share), outperforming the aggregate of its peers over this period. This was largely a function of the sharp increase in the PGM basket price (shown in Graph 1), which in turn was driven by the skyrocketing palladium price – it rose by 96% in the final year of our investment. As most market participants focused on the unsupportive environment for platinum, they overlooked the favourable outlook for palladium. A deficit in palladium had resulted from insufficient primary production and wider global enforcement of stricter emissions standards, as its primary use is in light-duty gasoline vehicles.
Our funds sold Amplats when its share price exceeded our estimate of intrinsic value
We sold our last Amplats shares at the end of January 2019. Considering the share price levels at which the company is currently trading, it looks like we sold too early. However, we prefer to follow a rigorous, repeatable process of selling mean-reverters at our assessment of conservative intrinsic value. In many cases, this means that we end up selling long before the share price peaks. This is a risk we are comfortable taking, because when the market for a commodity is very tight (as it is currently for palladium), the resultant squeeze can push prices well beyond sustainable levels. We prefer to sell into this kind of environment.
Our assessment of Amplats’ current share price is that it presents increased investment risk
In isolation, we think the platinum price could be considered unsustainably low. However, the squeeze in palladium, coupled with several lifelines (attractive prices of PGM by-products and a weak dollar/rand exchange rate) means that producers are incentivised to expand PGM production, as profitability remains high at a basket level. Accordingly, platinum is likely to remain well supplied. The same can be said for palladium, given the current attractiveness of the palladium price and the surge in production of Chinese vehicles, which will provide an additional source of the metal once they age sufficiently for autocatalyst recycling. As a result, we believe that the rand price of the PGM basket is currently high, which means greater investment risk.
Our increased emphasis on margin of safety helps to keep the odds in our clients’ favour
When commodity producers are pricing in a scenario of sustained high prices we consider investment risk to be elevated. We prefer to buy when prices are low and to remain disciplined in selling when our required margin of safety diminishes. Although this has its price – we are likely to leave some upside on the table for investors with a higher risk appetite – we believe that it helps us to keep the odds in our clients’ favour.