Metals and Mining – Discounting Much More Than Appears To Be Going On

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SEE LAST PAGE OF THIS REPORT FOR IMPORTANT DISCLOSURES

Graham Copley

203.901.1629

graham@sector-sovereign.com

April 17, 2012

Metals and Mining – Discounting Much More Than Appears To Be Going On

  • The metals sector remains attractive in our valuation framework, and at the larger cap company level the appeal is broad, with the best only fairly valued, and most well below fair value. This suggests that a basket approach owning the group is appropriate.
  • Return on capital analysis when compared with valuation analysis shows the group to be outside the historic range meaningfully; suggesting that either relative valuation will improve or returns will fall. In other words, skepticism is very high

Exhibit 1

Source: Capital IQ and SSR Analysis

  • As indicated in our initial report, we think that this valuation discount is driven by near-term price movements and cyclical concern about demand as it relates to China. Industry specific metrics are good – returns are high, though declining from a cyclical peak, cash flow is good and balance sheets are conservative.
  • While cheap stocks and sectors can always get a bit cheaper, we see as much as 35% upside as the sector normalizes in value. Within the group there are individual companies that offer as much as 45-50% upside. For the sector to move to extreme historical cyclical lows there is around 16% further relative downside (which is not insignificant), but we do not see industry fundamentals that would support that.
  • In Exhibit 2 we introduce a skepticism measure, by summing the two variables in Exhibit 1. When the number is high, the combination of positive ROC deviation and discount from normal value is high – either the stocks are cheap or returns are expected to fall – skepticism is high. When the number is low, the combination of negative ROC deviation and premium to normal value is extreme, suggesting that valuations are too high or returns are expected to recover – confidence is high. The chart shows that the metals and mining space is at an extreme, confirming the data in Exhibit 1. As both measures are market cap weighted, no one company is distorting one measure versus another.

Exhibit 2

Source: Capital IQ and SSR Analysis

Doubt at an all time high.

In our initial research piece, “Redemption May Come, But Only To Those Who Have Truly Suffered” – April 4th 2012, we highlighted the apparent miss-valuation of the US metals and mining sector relative to the market, but also as an outlier to the rest of the industrials and basic materials space. In this report we look further into this and present data that would support a higher relative valuation for the sector.

The US metals and mining space includes a number of players in basic metals and a smaller group in precious metals. The latter group is probably too small to create an “index” as once market weighted it would be overwhelmed by FCX. As we look at valuation across the sector all large cap companies are comparatively cheap. The better performers are expensive, but there are only a couple and they are smaller cap so they have a minimal impact on the cap weighted index. Most stocks exhibit some reasonable discount to what we would term “normal” relative value. On a simple average basis, the precious metals names tend to be more fairly valued that the basic metals names.

Overall, this looks like an opportunity and more so as we do more analysis. Returns in the sector are not low – in fact they are above a rising trend. Cash is not an issue, nor is capital structure, unless you take the view that the group has enough financial flexibility to get itself into trouble with high priced acquisitions.

Looking at returns versus value – as was shown in Exhibit 1 on the front page – we are in uncharted space, returns have not been this high while valuations have been so low. Or put otherwise, returns would need to fall meaningfully to justify current valuation. This may well be an effective measure of skepticism when data points are in the top right hand quartile of the chart, and optimism when they sit in the bottom left quarter. We will follow up with work comparing this level of skepticism with other groups but based on the way the analysis was constructed, it would be fair to assume that metals are at an extreme within the broader Industrials and Basic Materials group today.

The main problem with this space is that there is a lot of noise – and much of that comes from China. China a large (greater than 30% of global demand in many cases) and is the marginal consumer for many metals and metal ores. Demand in China can be volatile and sentiment even more volatile. It is very easy to get wrapped up in the short term data and miss the bigger valuation picture. The stocks could get cheaper and more negative growth or consumption news out of China could do that, but it is not clear that they would get much cheaper on a relative basis because of this.

A secondary problem is supply, though this can cut both ways. There are some rather dominant sources of supply in some metals and while supply additions can lead to step changes in availability, pressuring prices, supply disruptions can result in very quick price recovery. We see no real evidence of either driver today, but supply disruptions are always an upside pricing risk.

Valuation has deteriorated slightly since the end of March

The metals and mining group remains in territory that it has only been in a couple of times in the past (Exhibit 3). The most prolonged period of relative undervalue came during the tech bubble when the market itself had a premium valuation and almost everything in industrials and basics looked cheap. We would argue that the S&P 500 does not have much of a premium valuation today, even taking into account what we believe to be above trend earnings for the S&P500. Coming off the relative lows of 2000/2001, the metals sector then had 5 years of volatile outperformance of around 75%. The more recent valuation trough in 2008 retraced itself quickly with a move of around 35%, most of which has been given back in the last 18 months.

We do not believe that the conditions which drove the valuation troughs of 1998-2001 and 2008-2009 are evident or even likely today, and we see far more likelihood that the chart trends back towards the mid-line in the near to medium term, than the sector continues to underperform. We outline a handful of reasons in the next section.

Exhibit 3

Source: Capital IQ and SSR Analysis

This is far from a broken industry

Exhibits 4 through 7 show the health of the Metals and Mining space, as defined by our US index. This is not an industry with a balance sheet problem, nor is it an industry with poor annual returns. The sector has not traded with this level of negative relative sentiment when its financials have been in this good a condition. In our view this speaks to the level of macro uncertainty that is witnessed in the valuation of this group relative to others. Metal demand is driven by economic growth and metal pricing is very volatile around swings in both demand and supply, with demand very tightly linked to economic growth. Net income margins and returns on capital are declining from cyclical peaks, but remain high in absolute terms. The change of direction would certainly be enough to bring stocks down from accompanying peak valuations, but we have not seen these.

Exhibit 4

Source: Capital IQ and SSR Analysis

Exhibit 5

Source: Capital IQ and SSR Analysis

Exhibit 6

Source: Capital IQ and SSR Analysis

Exhibit 7

Risk – China

The major risk to downside is that demand could fall further and that this would take pricing down further, pressuring both cash flows and returns – in other words, the skepticism could be appropriate. The perceived risk is China and we have clearly seen some weaker signals in terms of GDP growth and inflation recently, though the currency moves over the week-end suggest confidence that the economy is not heading for further slowing of growth. The chart below (Exhibit 8) shows the short trading history of the XME ETF and compares this with the overall Shanghai index. What was a lagging correlation 4 and 5 years ago has become more coincident recently, with the ETF showing more Beta that the index. If confidence in China does not return, this group will struggle to impress, but as indicated above – the level of relative doubt is already very high, which we would suggest limits the downside.

Exhibit 8

Source: Capital IQ

©2012, SSR LLC, 1055 Washington Blvd, Stamford, CT 06901. All rights reserved. The information contained in this report has been obtained from sources believed to be reliable, and its accuracy and completeness is not guaranteed. No representation or warranty, express or implied, is made as to the fairness, accuracy, completeness or correctness of the information and opinions contained herein.  The views and other information provided are subject to change without notice.  This report is issued without regard to the specific investment objectives, financial situation or particular needs of any specific recipient and is not construed as a solicitation or an offer to buy or sell any securities or related financial instruments. Past performance is not necessarily a guide to future results.

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