OLD ARTICLE – Originally posted on February 10, 2020
I’ve been invested directly in a growing, junior coal miner for going half a decade, amongst several other mining-related investments. Likewise, I’ve followed a wide range of mining companies closely for even longer and previously was invested in a mining exploration company and poked around a whole bunch of these too.
While I am no miner nor commodities specialist, I feel confident enough in the sector to say that I broadly understand it, the eccentricities of various resources, minerals & sub-markets, & the risks and valuation-metrics that matter.
And, after going a decade or more of looking through the sector, I’ve concluded that it is (dam) complicated.
(Forgive the bad taste in puns, relating to Vale’s tailings dam that tragically burst, creating a massive supply deficit in iron ore that has seen iron ore rallying to dizzying heights. And not a single analyst nor mining executive saw it coming!)
Hopefully, those articles are of interest in understanding both the individual companies but also how one can look at these sorts of stocks (including the mining-related upstream providers).
My objective here is rather to look at three investment lessons I’ve learnt in this space:
(1) You can be right for the wrong reasons & wrong for the right reasons:
As a fundamental investor, you can do all the research you want about a mining company. Go see the assets, work through the operations and financials, get to understand management and their strategy, and get to grasps with their commodity(ies) market(s).
These are the variables that you can control and will help drive the inputs into your valuation and, ultimately, your investment decision.
And you can still be epically wrong.
Likewise, you can throw darts at a board, hit a couple of mining stocks, and turn out being incredibly right.
The world includes a certain degree of what appears to be randomness. Particularly in the commodity markets where there are so many unknown variables that have direct impacts on spot prices and currencies, which in turn then have huge impacts on mining stock share prices.
Likewise, the operations of a mine include a wide range of hard-to-predict but well-known risks that can negatively (or positively) impact operations and a stock’s price.
The obvious “known unknowns” include that the resource body being mined is worse than expected, the mine collapses or labour/mechanical disruption stops/hampers the production or some adverse regulatory change negatively impacts on economics. But lesser expected risks include things like this stuff happening to a competitor (as was the case with iron ore miners when Vale’s tailings dam disaster hit), some technological/regulatory/system-change ramping up the demand for their commodity beyond existing demand curves (have a look at current palladium & rhodium prices), & a surprise takeover bid by some egotistical CEO busy empire-building with other peoples money (no names mentioned here).
Due to the vast number of unknowns, the global interconnectedness of commodity markets, the operating (and sometimes financial) leverage of mining companies, all these factors converge into what can be insane volatility of the underlying share.
The point I am making here is that an investor in this sector should have a healthy appreciation for both upside and downside risks, irrespective of how well they have researched something. While I would never advocate not researching a stock before investing, the work is no guarantee of success here.
(2) Sustainable mines do not exist a.k.a. “dividends matter”:
When you have dug up and sold all of a certain mineral resource in the ground, a mine has no value. At this point, it just becomes an expensive hole in the ground.
There is no such thing as a sustainable mine.
Too many times I have seen mining companies use the cash flows of a mine to build another mine. Thereafter, they then use those cash flows to build another mine. And so the music keeps playing…
Why would they do this?
Either consciously or subconsciously, the management team is basically “rent-seeking“. The rolling of one mine into another generates limited to no wealth for shareholders, but management often takes a small (or large) percentage of these cash flows as salaries, bonuses and wider remuneration.
Hence, who are they keeping the company operating for?
The logical capital allocation decision would be to run the mine as efficiently as possible and pay nearly all of the free cash flows out as a dividend, but very, very few executives do this.
Now, you need to start with one mine and build/buy another as you build a junior miner into a major. The material drop in your risk profile as you bring more mines on stream (lowering your individual mine risk by creating a diverse portfolio of individual mines under a single holding structure) can add serious value to shareholders if you get it right.
But few do, and rent-seeking looks very, very similar to this strategy…
Let me ask you this: in the last decade, has any single new mining company evolve into a new major globally-diversified miner? All the major global miners were built decades ago when mining laws & regulations barely existed, costs were crazy low and a visionary couple people put the foundations together.
Hence, if a company is not going to becomes a major, globally-diversified mining house (which is unlikely), shareholders need to see dividends. Not just a trickle, but a huge flood of dividends! The reality is that this is probably going to be the major source of their returns, in the absence of one of the majors swooping on them with a takeover bid.
(3) Position sizing is key:
Given the above risks, variables, volatility & the risk of executive rent-seeking behaviour, why invest in this sector at all?
A rich, well-positioned mineral resource that is carefully exploited in a conducive environment can generate significant economic value. It doesn’t just have inherent barriers to entry (you either own the resource or you don’t), but it also earns hard currency in a real asset (the USD-priced commodity) and can generate fantastic, annuity-like income with a free embedded option on the commodity it is digging up.
After all the research and risks are taken into account, the final lever that one can pull to manage the potential upside with the risk of the downside is position size.
In other words, make sure you are not overexposed to any one of these stocks, nor in total to this sector. If you do that, you should be fine, irrespective of the randomness of mining.