How the cash poured into mining turned to dust in investors’ hands
‘Where has all the money gone, long time passing…” What a sorry state of affairs for long-term investors in the mining sector, the ones who put their money into household names like Rio Tinto or Anglo American during the great commodity boom from 2003 to 2015. Over this period, the FTSE All Share Mining Index actually managed to underperform the broader market by a massive 39pc in spite of a powerful tailwind for much of the period.
Two factors have been behind this dismal outcome for investors: first, the hubris that marked many of the mergers made at the peak of the boom; second, the excessive nature of much of the capital investment that went to increase output as financial discipline went out of the window.
It also raises questions about the quality of the corporate governance operating at these mining firms.
To put the underperformance of the mining sector into context, it is important to remember that the price of oil trebled during the boom years, copper surged from 75c/lb to 400c/lb while the prices of iron ore, thermal coal, nickel and aluminium also surged on the back of huge demand from China. The boom only started to run out of steam towards the end of 2011 as the first signs of China’s economic slowdown appeared.
For us, the warning bells on China rang loud and clear, especially after Steve Davies, with whom I managed one of Jupiter’s UK equities funds until earlier this year, visited the country in 2011. We decided to sell out of the large mining firms we owned.
For senior management at most of the mining firms, the same warning bells seemed to fall on deaf ears. They continued to behave as if the boom times would last for ever by engaging in expensive takeover deals that seemed to make no financial sense, or investing heavily in new production that would become surplus to requirements.
Simon Toyne at Redburn Partners, one of the City’s most respected mining analysts, compiled what we would call a list of “Top Stinkers” – the deals in the mining sector we believe should never have happened. The list is a very long one but topping it is Rio Tinto’s infamous purchase of Alcan. Rio paid $40bn for the Canadian aluminium producer and so far $20bn has been written off; BHP Billiton’s purchase of the shale assets at Fayetteville and Petrohawk cost $20bn, of which $6bn has been written down; Anglo American paid $7bn for the Minas Rios iron ore assets, spent $9bn upgrading them and has now written off $13bn. Xstrata’s purchase of Lonmin shares deserves a mention; the shares are currently 97pc off their peak. Lastly, BHP made an ultimately unsuccessful bid for Canada’s Potash Corporation (TPC). The bid was worth C$40bn (£20bn) and was made just prior to the break-up of the price cartel and the collapse of the potash price. It failed because the Canadian government deemed TPC a “strategic asset”. How the investors in this strategic jewel feel, sitting on a loss of over C$20bn, given the company’s current market value of C$20bn, is something at which we can only guess.
The boards that oversaw this value destruction were not any ordinary boards but the great and the good of world business. What we have seen in banking and now mining is that in periods when particular industries are growing strongly, non-executive board members seem at best to do nothing and at worst to act as cheerleaders for ambitious managements.
I can only surmise that the day job of many non-execs, which often involves running large companies, makes it difficult for them to undertake proper scrutiny of complex projects as required by their non-exec status.
In a similar vein, it is interesting to look at the huge increases in capital expenditure that occurred in the “glory years” as companies sought to increase output. A recurring criticism of the City is that it remains too focused on the short term, forcing companies to curtail investment in order to provide shareholders with higher immediate dividend payments.
Quite how the many thousands of investing institutions from all over the world with endless different strategies, time horizons and objectives come to have a uniform, clearly expressed view on something as complex as the right level of annual capital expenditure has never been made clear. But let us be phenomenally generous and assume this politically convenient accusation is true outside of the mining sector. It certainly doesn’t apply within it.
In 2001, the combined annual capital expenditure of the 20 biggest mining companies was $10bn. By 2013 this had risen to $90bn. Total capex from the big 20 rose by $433bn in the period and capital employed by this same group went from $100bn in 2003 to $900bn by 2013. The sector serves as a case study for the speed and extent to which capital can be made available when it sees an exciting investment opportunity.
If we had seen much lower rates of investment, it seems likely the companies would be in a far better state. Once the investments are made they are there for ever. Most of the cost is incurred in digging out the mine. Once capacity is laid down it makes sense to run it at full tilt as annual operating costs are relatively small. Overcapacity is thus very hard to correct. Game theory takes over as each company hopes the others will cut back so they don’t have to.
The investment decisions made by management and overseen by their boards only stacked up if Chinese demand grew at the same high rate far into the future. No one seemed to question these assumptions. Management at Rio and BHP were only changed when the damage had been done. City investors should have been far more proactive, demanding better justification for the capital spend. A dose of short-term common sense was very badly needed and clearly wasn’t going to come from within the companies.
This is not the end of the world for the mining industry. Traditionally, for sectors that have gone through a cycle of boom and bust, the low point is marked by a large-scale bankruptcy in the sector. The survivors can then buy cheap, distressed assets and start to rationalise the industry. That point may not be too far away.
‘Investment decisions taken by management only stacked up if Chinese demand grew at the same high rate far into the future’