It seems like it was only a few weeks ago, and indeed it was, that we relayed the best performers in the FTSE 350 were our picks of Lonmin, Bumi & ENRC. Well, in the space of just over 3 weeks, certain of the mining stocks have fallen by almost 50%. Yes, that’s right 50%, whilst the FTSE has rallied towards new highs. This is actually one of the fastest dislocations in the market of sectors since late 1999/early 2000 when the “old economy” stocks were sold down to crazy levels whilst tech stocks moved to stratospheric ones. Are we in a similar situation again with the likes of Kazakhmys down some 43% from where they were at the end of Feb?
Out of 38 FTSE 350 sectors, there are in fact only two in the red this year as global monetary easing has continued to pump confidence higher and cause investors broadly to return to the equity asset class. Lagging behind almost every sector is mining which is currently showing a loss of 8.6% for the year, only better than that of industrial metals which has lost more than 17%. Is there a reason for this massive underperformance experienced in mining and in particularly in the gold miners? There are some good reasons why the mining sector isn’t rising with pockets of oversupply, renewed corporate governance fears, recent large scale asset write downs etc but in relative terms, we think this is an excellent multi year opportunity to add certain stocks to one’s portfolio.
While it is becoming tougher and tougher to justify buying shares at the top of the performance ranking tables, there are some good reasons to pick up gold miners. The sector is out of sync with gold prices and many companies are trading at a near generational discount in terms of book value. We should expect some M&A activity in the near term as the stronger capitalised companies take the opportunity to consolidate. We suggest you read the latest edition of our magazine in which we pick 5 gold miners for the medium term. We included four UK companies and one from the USA: Avocet Mining, Aureus Mining, African Barrick Gold, Amara Mining, and Iamgold.
We havein fact been bearish on gold since the autumn of 2012, due to the mix of an improvement seen in the US economy, a decrease in the Eurozone’s “perceived” problems (Cyprus notwithstanding!), a wholesale move into riskier assets, and more recently the relatively mild solution to the fiscal cliff and debt ceiling issues in the US. All these factors highlight the fact that gold is even more costly to hold as investors are losing opportunities with the rising equity market and so diminishing further the attraction of gold. Even though all these factors are against gold prices and somewhat against gold miners too, we are still confident in the sector as we believe there is a massive disjoint between gold prices and gold miners that must be filled.
If we look at the following chart, we can see that while the gold price has been moving sideways since July 2011, gold miners have been losing value at a rapid rate. The link between the two has been broken and mean reversion will likely occur. We expect the gold mining sector to rally materially throughout the balance of the year on the back of M&A and an asset allocation rotation into the sector by institutional investors.
While gold has risen 7.2% since July 2011, the FTSE 350 mining sector has lost 31.4% and gold miners, or if measured by the Market Vectors Gold miners ETF, 30.1%.
Gold mining is an operationally geared business. Explorers usually have high fixed costs with their revenues highly dependent on the price of gold. When gold rises, share prices of gold miners are expected to rise by a greater degree than the rise in gold prices and vice versa. That hasn’t been happening for nearly 2 years now and as a result Many are trading at a heavy discount to book value and on EV:EBITDA ratios of sometimes just around 2 - a level which is usually a steal.
The wider mining sector is also heavily oversold at this point with Rio down 25% this past month, Lonmin a similar amount, ENRC almost a third from its peak and worst of all Kazakhmys nearly 50% - in the latter’s case it is trading at a discount to tangible book of almost 40% and this includes writing ENRC down to current value.
Kazkhmys relative to FTSE YTD
We contend that we are within days of a sharp rebound for the wider sector and called the turn almost to the day last November (see here - http://www.spreadbetmagazine.com/blog/second-train-leaving-mining-sector-opportunity.html). We have positioned ourselves accordingly.
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