The rally in Resources stocks in the first three months of 2016 has prompted substantial debate, centered on "will the rally last". Given the rapidity of rerating enjoyed by many mining stocks, including large companies, it is almost certainly not a rally that will endure. However, it is evidence of a substantial change in sentiment towards miners. The realisations that miners are 1) cheap and 2) probably have very little downside on price, have now set in – It would be very hard to “un-realise” that.
The last time Resources equities had a rosy tint to them was 2011, and since then there has been five hard years for miners. Commodity prices are now well off their (in many cases, all-time) highs, the realisation that China would at some stage taper it’s demand for commodities having long since set in. Falling commodity prices exposed the cost structures of many miners, which had all crept up in step with the price of whatever they produced.
All of that is now history however – for the first time since 2011, the first almost three months of 2016 have been very solid for mining equities. Breaking down the Australian market into key sectors, gold equities have been the star of the show, with the Australian Gold Index up 35% (at 9 March) year to date. The ASX200 Resources index is next best, at 8%, and closest others are REITS (3.1%) and Industrials (2.9%), the rest are marginal to negative returns in the same period. Miners have recovered a small part of their swagger of years gone by !
This rally stands out for several reasons:
- This is the first time miners have outperformed the rest of the market since 2011 (other than a few short phases where miners were just flogged less than the rest of the market)
- So far, the rally has been quite abrupt
- Since the point at which prices all seemed to turn (mid January 2016), there has been a raft of small mining companies raise money. Granted, small amounts, and off a low capital base, however this is another "first-time-for-a-long-time", as the market for fund raising, especially for small, non-producing, illiquid companies in mining has been all but closed for many years.
The drivers of this recent rally are fairly clear and thoroughly discussed – commodities broadly are benefiting from a strengthening US dollar, and gold is seeing interest from investors seeking a safe haven – fearing the prospect of low to negative interest rates for longer, or just possibly the prospect of Donald Trump becoming the President of the United States. A rally in commodities has driven equities, the stand out performance of gold miners has been down to the margins they are enjoying, as they are well ahead of their contemporaries on cost and balance sheet management having been forced into action when the price for gold collapsed in 2013.
The big question, which many commentators are now claiming to have the answer to, is “will it stick” ? Any rally that occurs off the end of five years of falls, especially one that is so rapid, is at high risk of petering out. Much of the commentary has centred on this key theme, and it is fair enough. However, that is not quite the answer to the question. From the point of view of the mining cycle, which is driven by liquidity either coming to, or departing from the sector, the perspective is necessarily longer term than “it’ll peter out soon”.
The rebounds of prices for companies such as BHP Billiton and Rio Tinto since mid-January 2016 are far too aggressive to reflect a change in fundamentals for what they produce. True, commodity prices have risen, but comparing prices of equities and commodities is an excessively basic analysis. The end of a bust in any cyclical investment space is characterised by a capitulation event, which itself culminates in the collective realisation by investors that the sector is too cheap to ignore any longer. A great deal of commentary from investment analysts and press is around the prices of miners and strongly reflects this sentiment. Add to this however both BHP Billiton and Rio Tinto cutting their progressive dividend policies in early 2016, after which their share price performances have been positive. This flies in the face of conventional logic, as both stocks massively reduced their yield. The perspective of the market however is that both companies needed to abandon those dividend policies to reflect their ability to generate cash to fund future dividends (alongside servicing debt and capital investment), so when the new policies were announced, miners went from “risky and deluded about the future” to “rational and sensible”. Lay that alongside being “cheap”, and the mindset shift has actually been quite substantial.
Gold companies collectively are now exhibiting quite impressive cash generation, driven by low costs and a robust price (especially in many producers currencies). With history as a guide, when rising equity prices line up against increasing cash balances, company aspirations usually shift toward growth, rather than dividends to shareholders. The climate in the gold space looks right for the beginning of balance sheet funded M&A, for several reasons.
- The largest companies are well funded thanks mostly to their assets producing cash
- Very few (in Australia at least) have many company changing growth options, most feature various degrees of brownfields extensions. If they want new mines, they are most likely going to have to acquire
- If big is good, more is better
Of crucial importance is that investors are once again funding fresh raisings of micro-cap miners. This strongly suggests that there has been an immense change of heart – only a few months ago, these stories were judged as too risky for most investors to bother.
The conclusion is not centred on the longevity of the recent rally for miners and commodities – the rally is only an important piece of evidence. It appears that investors broadly have changed their view of miners, and the realisations that miners are 1) cheap and 2) probably have very little downside on price, have now set in – It would be very hard to “un-realise” that. The present rally probably won't the stamina to maintain the impressive returns shown year to date over the longer term, however it appears very clear that capitulation is over, and the beginning of the return of liquidity to mining equities is well underway.
The tide has turned. Its the next rally, and the one after that that we need to worry about.