The enthusiasm that greeted rumours of a takeover bid by Glencore for Rio Tinto to create a £100bn mining and commodities-trading giant was in no way dampened by the sector’s current poor health. At The Value Perspective, our shopping list of stocks often contains some of the worst-returning share prices over the past quarter or year. That being the case, the table below might suggest base metals mining stocks should be piled high in our investments, but they are not. Why is that?
Source: Bloomberg 2014
For The Value Perspective, it comes down to the lack of a valuation floor in the sector. A good way to underline our concerns is to consider the price of iron ore, which – as the following chart shows – stands at around half of its 2013 peak.
Source: Bloomberg 2014
The trouble is, as the chart below illustrates, that price is still significantly higher than it has been for much of the last 20 years. It therefore seems reasonable to suggest investors in mining company shares either need to have a reasonable thesis as to why the iron ore price will stay at very elevated levels compared with its long-term history or be confident they will still make money even if it halves again.
Source: Index Mundi 2014
We do not believe we can predict the future, nor are we claiming iron ore prices will fall back to $54 (£34) a tonne – we just want our investment to be able to survive such mean reversion to a long-term inflation-adjusted price, and also offer a decent cashflow yield with a sustainable balance sheet if that situation were to persist. We would be keen to hear suggestions of miners that offer these characteristics but, so far, we have failed to find any ourselves.
We are not closed-minded to investments in the sector. We actually remain of the view that mining is an industry with better dynamics than it has had in the past and indeed iron ore has particularly positive aspects – not least the fact that a significant proportion of the market is effectively a global oligopoly. Unfortunately, there is little in the history of the sector to suggest that greater consolidation actually leads to better-run businesses.
There is also a very negative dynamic to commodities, which is that the best ways to reduce costs – by building more cost-effective mines, say, or investing in more efficient machinery – tend to involve producing more of whatever it is you are mining, which in all likelihood also reduces prices. What is more, in the case of iron ore, what you are mining is one of the most abundant minerals on the planet.
Iron ore is not scarce; unlike copper, say, it does not degrade over time; and, even after the recent falls, it still costs less than half of its current price to produce. To our eyes, this is hardly the time to get more involved in the sector although it appears Glencore thought differently. Maybe the company was looking at the iron ore price in the context of the last few years rather than the last few decades but, just because something has fallen in price, it does not mean it is cheap. It may turn out Rio did it a favour.