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Despite the strong performance from diversified miners this year, investors remain wary of resources. Hanré Rossouw discusses the opportunities in a sector where valuations are still not stretched.

 

Transcription

Lindsay Williams: As always on a Tuesday, it is the Investec Asset Management sponsored Big Picture. On the telephone from Cape Town is Hanre Rossouw, Portfolio Manager responsible for resources at Investec Asset Management and we are going to talk about, Hanre, first up, if you would, your selfless trip to the United States of America to attend two quite important conferences. What was the mood out there (I think it was two or three weeks ago)?

Hanré Rossouw: That’s right, Lindsay. I drew the short straw to attend a mining conference in Miami of all places.

Lindsay Williams: Bad luck!

Hanré Rossouw: I have got to say the mood was very strong this year. We have had a record attendance of global investors in the mining sector and I think that is underpinned by still a very strong performance by the diversified miners, so Anglo, BHP, Glencore very strong cash flows at the moment. Perhaps no surprise then that, if one looks at the JSE, the best performing sector this year has been the resources sector.

Lindsay Williams: Yeah, it really has been and that will, hopefully, continue. Whether it be because of a weaker rand or whether it will be a continuation of the strong cash flow performances of the diversified miners, I don’t know. Where would you say we are when it comes to that sort of generation of cash flows, free cash flow in particular, because obviously commodities are cyclical and you suddenly get to the point where it suddenly ends and doesn’t fall of a cliff but valuations start to look a little bit stretched and the whole cycle starts on the downside again? Where are we in the cycle would you say?

Hanré Rossouw: I think the interesting thing is, Lindsay, we are still suffering from a bit of the near-death experience in the end of the super cycle which peaked – the China-driven cycle peaked in 2008 and ’09 and then a secondary peak in 2011. So we have just been through a dramatic bear market of about five years.  Things really turned around in 2016. So I think investors are not quite there yet in terms of stretched valuations.  If one looks at the relative valuations, the mining stock is still relatively cheap against other sectors.

So I think there’s a general disbelief that the companies will be able to sustain the cash flows they are generating at the moment and investors don’t yet trust management not to destroy value by bad allocation. So there is a continuous call for increased dividends, increased buybacks and, hopefully, that keeps the miners honest this time.

Lindsay Williams: Do you ever get the sense that the same mistakes of the past are not going to be made again? I mean we say this every time there’s a cycle and every time we look back at the cycle, we say look what they did when the market was right at a peak.  They actually made this acquisition which was far too expensive but, of course, they were using their own equities, which were expensive, in order to make that acquisition. Can that happen again or did you get a more sort of circumspect responsible attitude from the people that you spoke to when you were in the United States?

Hanré Rossouw: I would certainly say it’s the latter, Lindsay. The theme of the conference was “value over volume” and I think what really destroys a cycle is high prices that leads to new supply being built. I would say M&A is generally good because you buy new units or you buy existing units, moving that into your portfolio, not necessarily adding new units to supply but it is really kind of badly timed and badly scheduled greenfield growth in the mining sector that destroys the cycles where you add more supply than is needed. Obviously, when there is a little bit of a dip in demand, that will lead to a collapse in prices.

So at the moment, there’s not a lot of new supply coming on-stream if you look at the capital expenditures of the miners. It is about a third of where it was at its peak. Some would argue it is not even enough to sustain existing or current production levels.  On the other hand, the demand side is still strong.  We have got kind of reasonably robust global growth. China is still surprisingly robust and I think people were betting on a weaker second half from China and, if one looks at the numbers, it could actually be a flat half-on-half for China, so pretty robust growth in China as well.

Lindsay Williams: Increased supply, of course, can’t be turned on and off like a tap, certainly not new supply anyway.  Did you get a sense that perhaps, because of the capex which is way below what might have been expected a few years ago if we were in the same position then – do you think that it will start soon and then in two or three years’ time the supply will be turned on and away we go to the downside again?

Hanré Rossouw: Not yet. I think if one looks at the risks to the current mining cycle, it is certainly not supply. It takes at least five and probably, realistically, seven years to bring on a new mine. If one just looks at the copper industry, there are very few new mines on the horizon. The only real exciting one is probably Quellaveco, one of Anglo’s copper projects.

So I think the risk is probably more a demand shock. So an emerging market crisis or a European crisis or a political crisis in the Middle East or Asia, that could be the potential risk. I think from the supply side and from discipline on the miners’ side, I see perhaps less risk than we have seen previously. We are not there yet.

Lindsay Williams: Let’s talk about South Africa, if we can, and let’s talk about the Mining Charter. Let’s talk about mining nationalism and let’s talk about something that takes me out of my depression today when I went to social media and I saw a very high profile political leader talking about a revolution potentially in the future and he couldn’t rule out the killing of white people although he is not calling for it right now, which wasn’t much comfort to me, and when I see GDP numbers and all sorts of other things that have taken me into myself a little bit when it comes to optimism about South Africa. Can you give me anything positive when it comes to mining?

Hanré Rossouw: Certainly, Lindsay. I spoke about the resource sector being the outperformer this year. So it’s up about 16% where industrials and financials are down 5% and 8% respectively. If one unpacks that 15, 16% return on the resources sector, effectively all of that came from the offshore diversified players, so Anglo, Billiton, Glencore, Sappi, Mondi. Those are all really businesses with operations outside of South Africa and, if one looks at the returns on the South African miners, those have actually been very bad this year. So Sibanye, Arcelor, Northern, Impala all down around 30-40% this year and, yes, it has been a function of a strong rand but it has also been a function of very bad politics and I think that has been to me the disappointment. Where we had promise of the Mining Charter being sorted out, more certainty around the regulatory environment, sadly, we have not had many advances on that side of the economic sector.

Lindsay Williams: Are you impressed with the new Minister? He started off quite well I thought, saying all the right things. Has he progressed?

Hanré Rossouw: Yes, I think it was certainly great to see a change in the Mining Minister in February. So Gwede Mantashe came on-board. He immediately came on with a lot of promises. I think the key thing, of course, for him is to sort out the Mining Charter 3. There has been lots of debate about ownership and I think it has been quite – it is an open secret that we are moving from 26% to a 30% requirement in terms of black ownership.

What has been worrying more recently though is there is talk of a 10% free carry where we have not seen that previously. The rumour is that we could see a 5% to communities and a 5% to employees where effectively companies will have to give away 10% of their business to effectively get to the 30%. It is not quite clear kind of where these rumours come from. In South Africa, we have got this tendency to be quite alarmist and to negotiate through these wild rumours. So we might see a little bit more of a pragmatic outcome in the end but it is certainly worrying to hear those sorts of rhetoric coming out.

To me, it sounds very much like we have seen in the DRC or Indonesia and I think that puts South Africa in a very bad category if one looks to attract foreign investment. Cyril Ramaphosa talking about $100 billion that he wants in foreign investment in South Africa and, if we go down that sort of demanding free carry for empowerment and just coming down on a mining sector that is already struggling, I don’t think we will see any new investment in the South African mining sector.

Lindsay Williams: Land expropriation, of course, the D-day, so-called D-day, is almost upon us and you can’t say land expropriation without people from overseas who don’t know the intricacies of the process or the potential process – you can’t extricate the mining industry from land expropriation or they can’t anyway. Is it also casting a negative pull on the industry?

Hanré Rossouw: No, I think that certainly as well, Lindsay. I think one has to be realistic about just the resource endowment of South Africa. I think certainly transformation is needed in South Africa but I think it has got to be sensibly done that we can actually grow the mining industry, recognising that the gold sector, for example, is a sunset industry. At the moment, we are running out of high quality reserves and, incidentally, I think that’s a big reason why we are seeing a lot of safety incidents kind of more recently. Platinum is also going through a bad patch but, on the other hand, coal and iron ore are looking a bit better.

So I think also that kind of where you do apply transformation goals, one has to be realistic about the strength of the underlying businesses and take a bit more of a pragmatic approach in terms of the rules and regulations that are laid down.

Lindsay Williams: Can we have a look at a couple of stocks that you like? One thing that keeps on coming up almost every couple of days on the show when it comes to talking about what happened in the markets is: oh look, Impala Platinum has gone up another 3, 3.5% but it is coming off such a low base. When you look at the platinum sector and you talk about gold being a sunset industry, platinum, of course, is not a sunset industry but it is behaving like that when you look at the shares on the JSE.

Hanré Rossouw: Platinum has gone through a very tough couple of years and I think Impala, Northern, Lonmin, Sibanye (which you should probably call a platinum stock these days) are all down around 30-40%. It has been a tough year just with the strong Rand. So we have seen the Rand strengthen going into March/April. More recently, we have seen a little bit of relief from the recent weakness but I think the sentiment still on platinum itself is very negative.

We have seen Dieselgate in Europe have significant negative impact on the penetration of diesel vehicles. You have got the quite alarmist concerns about electric vehicles that will mean the end of the internal combustion engine. Now this has all been weighing on the platinum prices. I think certainly we take a little bit more of a considered approach when we look at platinum supply and demand fundamentals. I think one has to recognise that electric vehicles are going to have an impact on the demand for especially diesel vehicles but, if one takes a realistic view, on the supply side I do think there is still a strong investment case for platinum and PGMs in general.

So we still hold platinum stocks. I think the excitement for me at the moment is still diversified so we have been very happily investing in BHP, Anglo and also Sasol. I know you said you are a keen follower of the football and the World Cup kicking off soon -

Lindsay Williams: Yes.

Hanré Rossouw: - the opening game, of course, there is Saudi against Russia and that is going to be an interesting little oil meeting there itself as well. The crown prince will be with Putin in the box and I am sure they are going to not be talking just football. They will certainly be talking oil as well.

So I think kind of one has to look at a diversified exposure. We happily hold platinum but we balance that with exposure into copper, oil that we get through Sasol and Billiton and then also Glencore is another stock that gives you offshore exposure although again with some political risk.

Lindsay Williams: Speaking of Saudi Arabia and Russia, a very well-known Wall Street banker has run some incredible programme, an 'algo' or something, and put all the teams of the World Cup into its computer and spewed out the results.  Brazil are going to win but it says Russia won’t make the knock-out stages and Saudi Arabia will be the surprise team of the tournament.  We will wait and see but, Hanre, thank you very much for a sobering assessment of the resources sector at the moment. That was Hanre Rossouw from Investec Asset Management in Cape Town.


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