Investors stockpiling miners in spite of soaring share prices
17 of the top performers on S&P/TSX are mining firms: Can the rally last?
It feels like a lifetime ago, but only five months have passed since investors thought Canada’s two biggest copper miners were at risk of collapsing.
In mid-January, Teck Resources Ltd.’s long-term notes traded as low as 38.5 cents on the dollar. Meanwhile, the debt of First Quantum Minerals Ltd., one of its chief rivals, traded between 40 and 45 cents. The mining industry was drowning in debt and the market feared that big-name companies were heading for painful restructurings, if not outright failure.
It’s easy to see where that kind of thinking came from. Commodity prices were plummeting, and most experts thought they were going nowhere for at least the next few years, possibly the next decade. Stock prices across the mining sector were at multi-year lows, and investor sentiment on the sector was arguably the worst it had ever been.
It is a different world today. Nearly every significant mining stock has doubled, tripled or quadrupled from its mid-January low. The debt concerns, which were front and centre over the winter, are long forgotten. Money has been raised across the sector — even some of the micro-caps on the long-neglected TSX Venture Exchange managed to get their hands on cash.
The sector’s stock performance has been simply incredible. Every one of the top 10 performers on the S&P/TSX Composite Index so far in 2016 is a mining company, as are 17 of the top 20. It is a complete reversal from 2015, when the worst performers were all mining and energy firms.
The initial bump in January and February was not surprising, since the stocks were absurdly cheap and a relief rally was inevitable. But many onlookers have been stunned at how they have continued to rise over the past several weeks.
Now the industry is facing a new, albeit less problematic concern: That the rally is completely overdone, and there will be a lot of pain to go around once the euphoria runs out.
One red flag is that mining stock prices have vastly outperformed the underlying commodities. Metals such as gold and silver have strongly rallied from their January lows, but others are up only modestly. Copper and aluminum, for example, have gained about 11 per cent each.
Some equities now appear to be priced based on significantly higher commodity prices.
Experts do not think these commodities are about to bust out: supply is ample, Chinese demand remains wobbly and the Brexit crisis has boosted global economic uncertainty. The one big factor working in favour of commodities this year has been a weakening U.S. dollar, and even that has rallied since the Brexit vote.
The days of China growing 12 per cent a year are also long over, and the general feeling is that gains in industrial metal prices are likely to be far more modest than they were a decade ago.
As a result, the calls for a correction have become louder as the stocks move higher. Teck now has more sell ratings than buy ratings from equity analysts, which hardly ever happens in Canada’s cosy brokerage world for any company not heading to zero.
“The rally is not sustainable at all,” said portfolio manager John Stephenson, who runs his own asset management firm in Toronto.
“If you’re an investor, you have to ask yourself, ‘Why won’t these go down?’ The fundamentals haven’t changed, and the commodity prices are likely to move down because there’s too much capacity.”
Stephenson shares the prevailing view that the sector’s rally started because equities were oversold and priced in the risk of bankruptcy (which was never going to happen). But now he thinks they are factoring in big gains in commodity prices, and he doesn’t see how those will materialize.
“You’ve got banks trading at a discount, and metals companies trading at a premium to their (net asset value). It makes no sense,” he said.
Independent mining analyst Terry Ortslan noted another factor behind the rally: after all the industry consolidation of the past 15 years, there simply aren’t many quality mining stocks to invest in. Once the sector rebounded, the remaining ones were bound to attract a lot of capital and post huge gains.
“There’s no surprise Teck moved up by a factor of four, and First Quantum the same thing,” he said. “The market is not looking at the price of copper. It’s looking for the next momentum generator.”
Ortslan added that the industry continues to suffer from a number of entrenched problems that haven’t gone away: high taxation, lack of new discoveries, permitting challenges and the virtual disappearance of M&A premiums. Put together, he does not expect this rally to last much longer.
But others disagree. For one thing, there is increasing confidence that January really did mark the bottom after a brutal four-year bear market. Commodity demand remains relatively stable, and supply will come under pressure over the next decade as the industry finally pays the penalty for years of under-investment.
This dynamic is already happening in zinc, which has outperformed other base metals this year as old mines have closed and not been replaced by new ones.
And equities still look affordable on some metrics, experts said. Ian Nakamoto, director of research at MacDougall, MacDougall & MacTier Inc., said Teck was trading at 15 to 20 per cent of replacement value at the bottom of the market.
Today, it still only trades at about half of book value, he said, adding that it has traded far above book value during previous stronger commodity price environments.
“It’s fair to say the worst is over for these natural resource companies,” he said.
“A major retracement in commodity prices seems unlikely barring recession, and I don’t think a recession is very likely.”
Only a minority of investors think base metals equities are a screaming buy at this point, but a far greater number remain convinced gold stocks are going higher, despite this year’s stellar performance.
If you’re an investor, you have to ask yourself, ‘Why won’t these go down?’ The fundamentals haven’t changed.