Allan Gray’s views on commodity markets and diversified miners

The free fall in commodity prices and associated shares towards the end of last year and its subsequent rebound has scarred and confused investors to the point of insanity. So how do the cards stack up now? We asked recently appointed chief investment officer of Allan Gray, Andrew Lapping, to explain the world as he sees it to us.

One of the funds that Lapping oversees – the Allan Gray General Equity Fund – was overweight basic resources against the All Share Index as at the end of March, with an exposure of 21.2% vs the All Share’s 17.2%. The fund also held an additional 1.4% of the portfolio in “commodity-linked investments” which includes Exchange Traded Funds (ETFs) holding physical gold, platinum and palladium.

According to Lapping, the developments of the last eight months have been shaped by the collision of declining Chinese demand with increasing supply for most commodities. “Mines take a long time to build and many of these were started in the good times, so supply has still been increasing, with copper being the most obvious of these. It’s also very hard and painful to reduce supply, and many operators will hold off as long as possible to do so because if you close down, it immediately benefits your competitors.”

As lower commodity prices got factored in though, so the share prices of miners followed commodity prices down.

But there are signs the balance is moving towards equilibrium. Lapping cites nickel as an example where a number of end-of-life mine closures have been complemented with temporary shut-downs of facilities by the likes of Glencore. But he also thinks that at current levels, there is no incentive for anyone to build new mines. Financing for projects has also dried up.

“Into the new year, metal prices rebounded – but are still very low – and we have seen investors who didn’t have commodity exposure scramble to get it. China has also stimulated demand temporarily,” says Lapping. This has seen prices rise from “exceptionally cheap” levels, with many company’s seeing its share prices double since the start of the year.

Share prices of large diversified miners over one year (Rebased to 100)

Anglo – blue, BHP Billiton – red, Glencore – Green

Screenshot 2016-04-29 13.19.24

Source: Iress

While the diversified miners make much about the benefit of spreading assets (mines) across commodities, Lapping thinks focusing on developing and investing in the lowest cost operations is the best way to ensure a resources company gets through the tough times. “It’s very hard to predict commodity prices in the future and besides, during times of crisis the correlation of prices is close to one anyway.”

Sasol is the general equity fund’s largest single holding, accounting for 8.7% of the portfolio. “We think Sasol has a very strong balance sheet and will be able to withstand a sustained downturn,” says Lapping.

The company is also undertaking huge capital investment in Lake Charles, Louisiana, which aims to exploit the difference between US gas prices and the price of plastics – which is typically linked to oil prices. “So the project hedges them to a degree,” says Lapping. “If gas prices (input cost) are low, the oil prices will be low too. So while it is a very large project, we think they will earn decent returns from it.”

Glencore is not a particularly big holding in the portfolio. “We think highly of management, and we like the trading arm of the business which generates good cash flow through the cycle and which acts as a buffer to the volatility in the mining business.”

BHP Billiton has far less debt compared to Glencore, “but they are highly exposed to the iron ore price. We have been quite negative on the iron ore price because of over-supply and poor Chinese steel production. We also think trying to pay a progressive dividend as a resource company did not make any sense,” says Lapping. (The progressive dividend has since been abandoned by the likes of BHP and Rio Tinto.)

On Anglo American, Lapping was cautious. “Their plan to deal with debt hinges on being able to sell a whole lot of assets, and we are not sure if it’s a great time to be selling assets. But they did seem to get a good price in the recent sale of the niobium and phosphates business.” [The $1.5 billion purchase price equivalent to more than ten times earnings before interest, tax, and depreciation]

In respect of the last three companies, Lapping could not comment on what was being bought or sold other than to say there was “activity”.