Just over a year ago I wrote two blog posts examining the behavioural and fundamental forces driving the mining sector, which at that time was approaching the trough of a multi-year bear market. With the help of some excellent research from Bernstein, I suggested that the current very low level of profitability within the sector was unlikely to be sustained for any length of time in anything but the most awful long-term macroeconomic scenario. I made the following comment:
“The combination of depressed valuations, very low market expectations, and strong historical evidence of cyclical mean reversion, suggest to me that the downside risk from here should not be that great. I believe the big money has already been lost in this sector.”
My statement 12 months ago was not based on the expectation of a massive commodity price rally. I was simply pointing out that market expectations had moved to a very extreme place, one that discounted an extremely negative fundamental environment that looked highly unlikely to surpass. Indeed I am as surprised as everyone else by the extent of the rally we have seen.
So where do we stand today post this huge rally?
To understand whether mining shares are still mispriced, it helps to revisit one of the charts from my original post which shows the revenue, profit and profit margin for the entire mining sector. The first chart is the one from 12 months ago and the second chart is an updated version showing the situation today.
What a difference a year makes!
Last year, using spot commodity prices the industry was earning almost the lowest profit margin ever recorded. Yet today the industry is actually back above average. Of course there are differences across individual companies and sub sectors, but it is clear there has been a huge shift in the fundamental position of this industry.
Most of this improvement can be explained by the rally in commodity prices themselves, which has increased revenues and profits for the mining industry. A secondary factor has been the ongoing fall in costs as the industry has continued to cut costs and improve overall efficiency.
It is clear from this chart that we are no longer in an extreme situation – mining company profitability is very much back to normal. The mean reversion has happened.
What can we say about valuations and investor sentiment?
A year ago, investor expectations towards the sector were extremely depressed. I showed the following chart, which details the historical profitability (using a return on capital measure) of the diversified mining sector (the blue columns). This can be compared with what is discounted into current valuations (the green dot). The chart showed that market expectations were for the mining sector’s profitability to remain very depressed for a number of years.
Fast forward to today and the same chart shows a more balanced picture. With the recovery in valuations across the sector, the green dot has now moved upwards such that the sector is now expected to deliver profitability close to its cost of capital (the green line).
This change may not appear that significant but it is. A year ago the sector was priced to make a real return on capital of barely 2.5%, whereas today it is priced to make a real return on capital closer to 4%. This is a 60% increase in the level of long-run profitability discounted in market valuations. This also happens to be more or less in line with what the average real return on capital has been over the long run if the China driven super cycle years of the mid 2000s are excluded. This seems reasonable to me.
In summary, the overall risk / reward profile for the mining sector now looks fairly balanced to me. Over the past year, the sector has transitioned from a position of extremity – in which profitability, valuations and sentiment were very depressed – to one that today looks a lot more normal. Of course there may still be attractive stock specific ideas within the sector, but in my view the big opportunity has now passed1.
1. This is no recommendation to buy or sell any particular security. This communication has not been prepared in accordance with legal requirements designed to ensure the impartiality of investment (strategy) recommendations and is not subject to any prohibition on dealing before publication of such recommendations.