Testing metal – Is the outlook for platinum really quite as dire as the market appears to believe?
The Value Perspective may not have focused on the platinum industry since June 2013 – that article’s title, Limping along, neatly summarising our downbeat view on the general health of the sector – but that does not mean we have not been keeping a close eye on platinum miners and, in particular, on Lonmin, the world’s third largest producer of the precious metal.
One interesting aspect about mining in general these days is that, although the prices of copper, iron ore, platinum and so on may have collapsed, the share prices of the businesses that actually dig these commodities out of the ground have tended not to have come back nearly as much as investors might have expected.
If you were an idealist, you might suggest this shows the maturity of the market – that it can look through the cycle and price these businesses for the long term. If you were a cynic, you might suggest this is how the market tends to behave just before it panics completely and capitulates. Whatever the reality of the situation, what can be safely said about the market is it does not like Lonmin.
In common with a few other commodities businesses on which the market has apparently given up, Lonmin is fairly narrow in its scope. It only mines platinum and it does so in a part of the world that worries investors – South Africa, an emerging market with well-documented labour, inflation and political issues. To complete the bear case, platinum potentially faces significant structural challenges.
Perennial starting point
That at least is the perception of the wider market and yet Lonmin also has some interesting points in its favour, the first of which is our perennial starting point – valuation. So let’s flip the bear case on its head and instead ask, what is the price we are being asked to pay for Lonmin and then, if we were to pay it, what would we have to put up with?
Well, at a share price of 122p on 28 March 2015, Lonmin is today trading on roughly 1x its peak profits and on less than half its tangible assets – in other words, you could in theory wipe out half the physical assets of the business and its valuation would not move. By all sorts of measures, it is exceptionally cheap.
What then is the risk attached to the business? The first place we look, of course, is the company’s balance sheet and that allows us to see Lonmin at present has next to no debt. That may not be enough should things get really bad – as bad as we are shortly about to suggest they might – but still, the fact a company is not significantly geared tends to be a good start.
There is, then, more to be said for the business than one might at first glance imagine but, as we have also hinted, there are undeniably some potential downsides. Foremost among these is that Lonmin is in a classic commodity company situation – it produces something for which there is currently too much supply and not enough demand.
Two principal concerns
Here the market has two principal concerns – the first being that this oversupply could persist for some time because mines tend only to be shut down as a last resort. The companies that operate them are keen to avoid all the stranded overheads that come from closing a mine while the countries where mines are situated are desperate to keep their citizens employed.
The second concern is platinum miners have far less control over supply than they used to. Platinum has two main uses – in jewellery and, less obviously, as an integral part of autocatlysts, which help control toxic emissions from car exhausts. As the auto industry grows more adept at recycling old cars – and particularly the more valuable components – so this area of platinum demand levels off.
One could of course argue the not insignificant demand that does still come from the auto industry is associated with a structurally growing area such as reducing car emissions and therefore hardly a negative in itself but, these days, you will be hard-pushed to find many investors with a good word to say about the platinum market.
That is just the way we like it, here on The Value Perspective, so let’s see what positives we can, as it were, dig up, For starters, we will flip the negative market view on its head by observing how, when we were looking at mining companies back in 2006, everyone was telling us platinum was the best commodity on the planet – better than iron ore, better than copper, better than everything.
Hard to find
The reason for this firmly-held opinion was that supply was so constrained because platinum is so hard to find – essentially there are deposits in southern Africa and a few isolated spots in northern Russia and northern America. That stands in stark contrast to iron ore or copper, say, which you can pretty much dig up anywhere in the world.
On the demand side, meanwhile, that whole autocatalyst story everyone is now so worried about was being pitched as a huge structural positive. So OK, half the market for platinum is jewellery, which can be seen as a little flaky – even if people rarely seem to make the same criticism about diamonds – and then there is the auto industry. A decade ago that was seen as great – but now? Not so much.
In all this, there appears to be an echo of the tobacco sector where, 20 years ago, the market could only see the downsides – for example, the constant threat of litigation and the awkward fact that cigarettes kill people. Well, cigarettes still do kill people but now investors tend to focus on more upbeat aspects of the tobacco business, such as strong market dynamics and low levels of debt.
Today, investors are unable to see anything but the negatives about platinum and yet, as we have discussed, there is potentially quite a lot to like about the sector. And if you are still not convinced, let’s throw into the mix the fact that almost a quarter of Lonmin’s entire market capitalisation is going to come to the market over the next few months.
An instructive episode
Yes, that really is a good thing – as we will explain in a moment – but first let’s revisit an instructive episode from the mining sector’s recent past, which saw Xstrata trying to take over Lonmin in 2008 for the equivalent of £62 a share. Thwarted in that endeavour, the company – itself acquired by Glencore five years later – stumped up £33 a share for an initial 10% stake and then £20 a share for 14% more.
Lonmin’s share price has since fallen as low as 110p a share – the sort of level it was trading at back in 1988 when Big, Rainman and Roger Rabbit were in the cinemas and Kylie, Tiffany and Yazz were top of the charts. Even so, Glencore can apparently see no value whatsoever in the asset and is looking to spin the shares off to individual shareholders, who will most likely look to sell them on.
Scenting blood, the hedge funds have been pummelling the share price into the floor, reasoning they can short the stock and then use that 24% of the company reappearing on the market to close out their positions. The price has therefore been in freefall to the extent that, while the wider UK equity market has been hitting all-time highs, Lonmin has, as we say, been revisiting 1988 levels.
The hit with which Yazz topped the charts back then was, you may recall, ‘The only way is up’. While experience has taught us never to say that of any investment – indeed, as value investors, we always have to fight the temptation to try and buy in at an even cheaper price – a valuation of half book value and 1x peak profits, in combination with the potential positives we have outlined, is tough to ignore.
Fund Manager, Equity Value
I joined Schroders in 2001, initially working as part of the Pan European research team providing insight and analysis on a broad range of sectors from Transport and Aerospace to Mining and Chemicals. In 2006, Kevin Murphy and I took over management of a fund that seeks to identify and exploit deeply out of favour investment opportunities. In 2010, Kevin and I also took over management of the team's flagship UK value fund seeking to offer income and capital growth.
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