Category Investments

Resources shares: The start of better things or tread carefully?

29 January 2013 Investec Asset Management

Daniel Sacks, portfolio manager at Investec Asset Management, outlines why he believes resources shares still offer investment opportunities, where he sees these opportunities given the risks in the local market and why the gold run is not over yet.

Over the last three years, the resources sector has not been a particularly comfortable place for investors, having underperformed the JSE’s All Share Index significantly over the period – the Resi 20 has barely gained more than 1% over the past three years. This is in stark contrast to the Alsi’s return of 47,8% over the same period.

As investor sentiment and risk appetite improved towards the end of 2012, there was sector rotation out of some of the more expensive areas of the market into resources. The burning question is: Is this signalling a return to favour for the resources sector?

Opportunities for astute investors

Judging by current valuations, the resources sector – with a historic price/earnings ratio of approximately 11 – seems compelling from a valuation perspective, especially relative to sectors that have enjoyed most of the attention till now, such as industrials (PE of 18) and financials (PE of 14).

However, although these shares might appear relatively cheap on the surface, this is not really the case, given that we are expecting significant earnings declines that are due to be reported for the December year-end.

For example, we’re expecting a 60% earnings decline for Anglo American, which will push its PE to approximately 17 or 18 (from current levels of 10). This is significantly more expensive than the broader market, which is currently trading on a PE of 13 times. Therefore, just because resources shares have underperformed, it does not mean that they are cheap.

Secondly, it is probably unlikely that we will see the support from stellar commodity prices over the next few years as we had become accustomed to during the last decade of the ‘super cycle’. Even though China has averted a hard landing and the US economy seems to be on the road to recovery, albeit slowly, the days of double-digit growth from China are behind us. Furthermore, commodity prices are now at much higher levels than they were when the super cycle began.

Investors therefore now have to evaluate opportunities in a much more benign commodity price environment.

We prefer to invest in resources companies that can grow earnings irrespective of commodity prices. These are companies that can advance by means such as volume growth and cost containment.

Rand weakness will also benefit this sector, although there is a caveat. Investors need to avoid those shares that may be contributing to the rand weakness, as we saw last year with the companies affected by the strike action.

The logic is fairly self-explanatory: As was evident last year, the instability caused by the labour unrest can contribute to currency weakness – which under normal circumstances would be beneficial to commodities. However, the very reason for rand weakness is debilitating the companies’ potential to generate an income.

Avoid labour risk

In the light of this, we prefer shares that are beneficiaries of rand weakness, but without the labour risk. In this space we are excited about a company like Sasol, which appears to be relatively immune to the risk of labour unrest and has the potential to achieve decent volumes growth.

Sappi and Mondi are other shares that meet these criteria and we have overweight positions in both stocks in the Investec Commodity Fund.

Given the challenges facing the local mining sector, we prefer shares that have less of a South African bias in its operations.

Another important consideration is the way in which companies pay wages – the more generous the employer, the less likely it is to be affected by strike action. Contrast BHP Billiton, for example, with Anglo. The former has only 6% exposure to South Africa and is considered to pay its employees fairly decent wages, while the latter generated 49% of its 2011 earnings from SA operations.

Platinum metal trumps shares

Platinum and gold still present value, but for different reasons. In terms of the former, we prefer the metal to platinum shares. The supply side is tightening, but the very mechanism by which the volumes are decreasing makes it unattractive to hold these miners. Although the lower volumes might lead to better prices, we don’t believe the earnings effect will be enough to make the shares appear reasonably valued in any way.

Looking ahead, we are also more worried about strike action in the platinum industry than in the gold sector.

Gold run not over

In terms of gold, we are more bullish about the prospects for gold equities relative to platinum. We do not believe the run in the gold price is over. The factors that support the gold price are still in place. Given the Fed’s indication that it would not raise rates, we can expect negative real interest rates until at least 2015.

Furthermore, central banks and individuals – particularly from emerging markets – are still significant buyers of the yellow metal. The uncertain economic environment and inflation fears are causing investors to turn to a known store of value.

Importantly, we believe the gold sector has drawn a line in the sand, as evidenced by the decisive way in which Harmony pre-emptively shut the Kusasalethu mine and gave notice to 6000 employees. It would suggest that the balance of power is shifting back towards management, which could prove to be a valuable bargaining tool when wage negotiations start in March.

Despite underperforming the market for the past three years, the sector does offer opportunities for long-term investors.

Daniel Sacks is portfolio manager of the Investec Commodity Fund. This fund has outperformed both its benchmark (the JSE Resources Index) as well as its peers over the one- and three-year time periods, and was the best performing resources fund last year (4.8% over one year, 4.7% per annum over 3 years). Over the past 15 years, the Investec Commodity Fund is the best performing unit trust in SA overall, across all fund categories and asset classes. Over this longer-term period the fund has returned 25% per annum.

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