Investing in small cap resources stocks can be a tricky endeavour, with fortunes made and lost on almost a daily basis. This is a risky segment of the market and it will come as no surprise to many that returns from resources stocks have been shown to be twice as volatile as returns from their industrial counterparts.¹
Many small cap fund managers shy away from investing in the resources space due to this volatility and a lack of expertise in the sector. However, these stocks currently make up approximately 20% of the S&P/ASX Small Ordinaries Index and ignoring them is forgoing a large part of the investable universe.
Here at AMP Capital Emerging Companies Fund, we firmly believe that this is an area rich with good investment potential, and that by following a clear process we can seek to maximise the potential for positive returns.
An Institutional Investor’s Perspective
It’s important to note that we don’t think of resources investing as much different to investing in other parts of the market. Our fund invests across many different sectors, however the core aspects we focus on remain the same namely earnings, sustainability, and risk.
Our investment philosophy is that earnings drive share prices, and that by accurately forecasting earnings our fund can outperform in most market environments. The earnings of resources companies are less predictable by nature given that they are mostly driven by the commodity price, which they usually have no control over. This leads to a high-level of earnings volatility and therefore share price volatility, but there are many common factors we look for before investing across both industrial and resources companies.
The First Hurdle
First and foremost, our view on the underlying commodity price is the key driver of returns across the resources sector, and as the old saying goes, “a rising tide floats all boats”. While there are many other factors that can influence returns (such as exploration success), it is generally uncommon to see share prices perform well in a certain segment if that commodity price is falling. This is the first test that an investment needs to pass for us. It is very rare that we will invest in a company if we have a negative view on the commodity it is exposed to.
For example, we have seen a few very interesting stories in the lithium space over the past year. However, due to our view that the lithium market was well oversupplied and expecting price drops, we did not hold any investments in this space over that period. Conversely, we have held a positive view on the gold price and, despite some cost headwinds in the industry, this has been a happy hunting ground for us in recent years.
Things can change very quickly in resources and while we may hold a negative view on a commodity now, this may not be the case if circumstances change. A recent example is the rise in iron ore prices following the sector supply disruptions. A big part of our job is keeping in regular contact with companies across the entire resources space, so we are able to be nimble and make timely investment decisions if and when opportunities present themselves.
The Five Forces of Resources
Most people who have analysed a business before will be familiar with the Porter’s Five Forces framework, which analyses a company’s competitive environment and positioning. The factors used in this analysis (competition, barriers to entry, supplier power, buyer power, and threat of substitutes) are great for assessing the sustainability of an industrial business’s earnings stream but hard to apply to resources companies.
However, we can modify Porter’s Five Forces and come up with a framework to assess the quality of resources companies – the ‘Five Forces of Resources’:
1. Management: Although one should exercise a degree of caution, past performance may be a good indicator of how a company will perform. Good management teams who make money for investors in one mining venture tend to re-appear and do it over and over again, and investors should do their research on the people behind a project by digging into their track record.
2. Mine life and prospectivity: Mine life is a major driver of valuation. Prospectivity tries to gauge the likelihood of exploration success and is a very subjective factor but an important one, especially for companies with a short mine life.
A company with a large reserve and resource base has the luxury of being able to plan out the future in detail, limit exploration spending, think about expansion cases, and take on more debt. A company with only a few years left to run has some difficult decisions to face. Do they harvest cash or aggressively explore to try and boost reserves? Do they cut back on maintenance capital given the short remaining life? How can they attract good people when prospective employees know they might be out of a job in the short term?
In our experience, mining CEOs tend not to want to put themselves out of a job by running down a mine and shutting the business. This leads to a much higher risk of poor capital allocation (misguided exploration or a risky acquisition). Some of the factors we look for in determining potential upside to mine life are: the assumptions that have gone into the reserve/ resource calculation, the deposit’s position (open at depth or along strike), the exploration budget and where it is being spent, and the potential application of any new technology, such as 3D seismic, to provide more data on a deposit.
3. Location: Geopolitical risks are ever present in the resources industry. Companies with an asset base in stable and secure countries such as Australia and Canada have attracted, and will continue to attract, a premium rating due to perceived safety. There are countless examples of mining companies in places such as Africa having issues with changing laws, additional taxes and royalties, and security risks. Investors have to decide how much upside they need to see to compensate for these risks.
4. Cost: This factor comprises both operating and capital cost, and relates to a company’s ability to finance a new project and remain profitable during a market downturn. In times of rising commodity prices, the companies with the highest cost bases may well be the best performers given they have the most operating leverage. However, over the course of a cycle the low-cost operations will generally outperform.
5. Balance sheet: In most cases, resources companies will take on debt in order to fund construction of a new mine, an expansion, or an acquisition. Unfortunately, many of these projects and acquisitions will fail to live up to expectations and lead to significant balance sheet stress. It is critical that companies are conservatively geared to allow for any capital cost overruns, commodity price declines, or other short-term disruptions.
Finding a company which looks attractive across all of these factors is the ideal scenario, however these are rare and often fully valued, given that other investors have come to the same conclusion as us regarding quality. We assess potential investments on a risk-reward basis – how much risk are we willing to take on for the valuation upside on offer? We usually won’t compromise on management quality or cost but will invest in companies with a short mine life, a less desirable location, or a reasonable debt load if there is significant upside to our valuation.
A Case Study
Saracen Mineral (ASX: SAR) is a company held in our fund for a number of years that ticks all the boxes we look for in a quality mining company. As mentioned above, we have held a positive view on the gold price, so this helped the company to leap over the first hurdle of our investment process.
In our view, Saracen is also one of the rare examples of a company scoring well on each of the Five Forces of Resources. We believe management is excellent and, after a slip up early in the mine life, have proven themselves to be strong operators who have consistently delivered results above guidance and market expectations, as evidenced in quarterly reports over the past few years.
The company’s 2019 reserve statement showed that mine life is increasing and is now at seven years based purely on reserves, with likely upside from resource conversion and a large ongoing exploration program. Both assets are based in West Australia, arguably the most desirable gold mining jurisdiction globally from a regulatory and workforce perspective. All-in sustaining costs (AISC) at AUD 1,050/oz are low compared to mid-tier gold peers and offer a 50% margin at current gold prices. The balance sheet is in excellent shape with over AUD 150 million of cash held and no debt, with a dividend policy declared for the first time at the recent FY19 results announcement.
We have a clear and rigorous investment process that we believe leads to successful investing in the resources space. Given the inherent volatility in this part of the market, there will be successes and failures, and it is critical that a portfolio of stocks is constructed to maximise potential returns without taking on excessive risk, with each stock assessed on its fundamental merits.
¹ Measured as standard deviation of returns for the ASX Small Resources Index compared to the ASX Small Industrials Index over a 10- year period
AMP Capital Funds Management Limited (ABN 15 159 557 721, AFSL 426455) (AMPCFM) is the responsible entity of the AMP Capital Emerging Companies Fund (Fund) and the issuer of the units in the Fund. To invest in the Fund, investors will need to obtain the current Product Disclosure Statement (PDS) from AMP Capital Investors Limited (ABN 59 001 777 591, AFSL 232 497) (AMP Capital). The PDS contains important information about investing in the Fund and it is important that investors read the PDS before making a decision about whether to acquire, or continue to hold or dispose of units in the Fund. Neither AMP Capital, AMPCFM nor any other company in the AMP Group guarantees the repayment of capital or the performance of any product or any particular rate of return referred to in this article. Past performance is not a reliable indicator of future performance. While every care has been taken in the preparation of this article, AMP Capital makes no representation or warranty as to the accuracy or completeness of any statement in it including without limitation, any forecasts. This article has been prepared for the purpose of providing general information, without taking account of any particular investor’s objectives, financial situation or needs. Investors should, before making any investment decisions, consider the appropriateness of the information in this article, and seek professional advice, having regard to their objectives, financial situation and needs. This article is solely for the use of the party to whom it is provided and must not be provided to any other person or entity without the express written consent of AMP Capital.