GAMBLING ON COMMODITIES
A risky bet for investors
The sad truth is that the commodity share market offers slim pickings. The investment world has been steadily – and not so steadily – losing money on mining investments for years. Why would you foresee better results? The fact is that the mining sector is suffering a hangover of skull-cracking proportions. Ill discipline, unrealistic expectations, and complacency all have their place in an examination of commodity markets in the last 10 to 12 years.
The ‘super cycle’, as it was known, was a spectacular place to be, however. Driven by unstinting growth in China, the 30 to 40 years from 2002 were meant to result in huge demand for steel and the stuff that goes into making steel, such as manganese and iron ore.
Since 2003, t he gold price gained 372%; iron ore became 302% more expensive, the price of copper increased 384%, while thermal coal gained 273% in price. At first, share prices responded providing investors with good capital gains.
Even now, the HSBC Global Mining Index is 235% higher t han in 2003, whereas the FTSE 100 and Dow Jones are 78% and 82% higher respectively. But share prices aren’t the whole picture. Since 2010, margins have been shrinking drastically. According to a study of the world’s top 40 mining companies by PricewaterhouseCoopers, the gross margin of the world’s principal gold companies fell 29% compared to the share price as a ratio compared to gross margins of 49% in 2010.
The acid test, however, has been the return on capital employed (ROCE),
a ratio that digs deeper than just earnings, and provides an insight into how effectively management has used capital.
At the beginning of the super cycle, mining companies used their money relatively well, with ROCE rising to 23% in 2006, from 5% in 2002. Thereafter, however, the trouble begins. As mining companies became more enthusiastic about the never-endi ng gift t hat was the super cycle, aided by talk
of I nd i a joining China as a world powerhouse, the spending on capital projects increased, and with abandon.
ROCE fell from 23% to 9% by 2009 amid the economic and financial crisis; it bounced back to 18% in 2010, but slipped again to 8% in 2012 – its lowest collective level in 10 years.
In the last two years, the breakdown of capital discipline in mining management started to reflect in the shares. The HSBC Global Mining Index declined 30% in 2011, whereas the Dow Jones Industrial Average was 16% higher from 2012.
As a result, investors are asking mining management to deal more carefully with their dollars.
First, though, there’s been a wide-scale clean-out of those in management, who have been replaced with new leaders whom investors have ordered to focus on cash returns, dividends – or yield, as it’s termed.
“Investors are saying this is their capital,” says Carel Smit, head of markets, energy and natural resources at KPMG in Johannesburg. “They are saying that they will invest in your iron ore mine, but don’t use the profits to buy a coal mine. Give it back to them in dividends.”
The catalyst for the failure of the world’s mining sector has been a decline in the rate of China’s economic growth to ‘only’ 7% or 8%. This has led to an adjustment in prices while in a separate development, the 10-year bull run in the gold price has been stopped dead in its tracks by potential changes to monetary policy in the US.
In South Africa, the picture is – somewhat depressingly – more complex. The promulgation of empowerment regulations in 2004, just as the super cycle was kicking off, muddied the investment waters in the country for potential new investors, who had more options anyway thanks to expansions in production elsewhere in the world.
Never mind new investors in SA. Existing investors have become anxious about issues