By David Stevenson –
Over the last few years, I’ve been developing an aversion to big themes. Like all journalists, I like a fancy-sounding grand narrative involving big subjects that matter, like China or emerging markets, in turn having a direct effect on the pricing of financial assets. It all makes for good copy and it’s also the stuff of fund management super-marketing, with lots of exotic photos and glitzy graphics telling us about amazing facts from China, India and Brazil.
David Stevenson looks at the energy and mining services sector.
The problem is that one person’s grand narrative of extraordinary global change is another investor’s graveyard. Most exchange-traded fund (ETF) investors will have by now heard of the extensive academic literature which suggests that there is in fact a negative correlation between national GDP growth rates and investor returns.
This extensive library of research is nicely summed up by the observation that in recent times investors would have made more money investing in boring, low-growth Belgium than exciting, high-growth China.
The investment challenge is that the various linkages that connect together top-line GDP growth and bottom-line shareholder returns is full of potential mishaps and economic agents looking to skim off profits. Take China. In the good old days when GDP growth rates were well above 7.5% per annum, earnings per share were indeed romping ahead at double digit rates but managers knew what was happening. The bosses of firms deliberately skimmed off their excessive rents, as did local and national governments.
More importantly, as earnings increased, competition intensified, and capital expenditure (capex) spiralled out of control, unleashing savage price wars and, eventually, operating margin erosion. Profits were thus skimmed away to capex, taxes, and bad management and those all-important dividends that comprise the majority of the returns from investing over the long term….well, they were, until fairly recently, non-existent. Paradoxically, I am of the view that declining growth rates for China might actually be better news for investors as the government forces tougher capital discipline and increased dividend payouts for investors.
But I digress – the real point here is that a big top-line narrative doesn’t always translate through into bottom-line profits. These grand narratives are useful, though, in guiding us to a sensible starting place i.e. how to start an investment research process. Unfortunately, they probably don’t tell us much about what to invest in – that requires all that boring investment research.
This brings me nicely to what I call the ‘Picks, Shovels and Roughnecks’ theme. I am absolutely convinced that the human race is slowly but surely degrading its way through this planet’s bountiful treasure trove of energy and key materials. Increasing population for at least the next two to three decades can only have a negative impact on our resource balances. But it’s at this point that my own grand narrative stops. The impact of growing wealth in the developing world will be uneven and difficult to translate into profits. To give just one small example, demand for coal may be increasing at the moment but I think this will all change over the next decade as the world’s grossest polluter finally meets its match. Natural gas may be bountiful now, but as industrial usage picks up, I think it reasonable to expect inexorable price increases. Over in the mining sector, there’s absolutely no shortage of some metals, impending disaster in others. The point is that each market is different and in each region/continent, impacts will vary considerably.
But for me there is one constant – we’ll need to spend a vast amount of money digging and drilling stuff out of the ground, at ever-larger scale and in more difficult circumstances. Thus starts an investment journey which suggests that energy and mining equipment manufacturers and suppliers are the place to be – but what to actually own? The key for me is not to buy a sector that can easily be copied by third world manufacturers, especially in China, eager to rush out the latest low-price tractor, digger, conveyor belt or shovel. As with any industry, we need to seek out businesses with a competitive ‘wide moat’ usually involving some form of proprietary design, engineering edge or market-leading position…or ideally all three. And then last, but by no means least, we seek to buy these quality business franchises at a relatively low cost.
The good news for any investor starting on this particular journey is that there are a number of ETFs that track key players in these sectors. The trick, though, is to make sure that the ETF – and thus its underlying index – isn’t just falling for a grand narrative, without any basis in hard business logic.
In a previous column, I mentioned my own interest in the recently launched London-listed Source Morningstar US Energy Infrastructure MLP UCITS ETF (MLPP / MLPQ) – this seems to be a simple investment strategy that capitalises on the need for new, expensive energy infrastructure in the US, which will in turn produce a steady income flow for UK investors. The fund has pulled in almost $120m since its launch in May 2013.
Equally, I’ve long been a cautious fan of the US-listed iShares US Oil Equipment & Services ETF (IEZ) that invests in leading US oil equipment and services companies (this fund has c. $407m in assets). I say cautious because it seems to me that a blanket strategy of buying the biggest companies in this sector is not necessarily the best; maybe a focus on those with deep sea interests is a more sensible step, especially as the more broadly diversified majors are very much more vulnerable to big capex cuts at the large integrated energy majors.
Over in the mining space, I have no particular view as to what might happen next with industrial metal prices but I am increasingly interested in the mining equipment and services outfits that work with the major mining companies. My own view is that over the next 20 to 30 years, we should see a boom in spending on resource extraction equipment, with more and more emphasis on smart engineering and better technology.
It’s against this backdrop that I’ve become more and more interested in a relatively new commodity focused ETF called the Pure Funds ISE Mining Service ETF (MSXX). This US-based ETF hit the NYSE Arca market in New York at the back end of 2012 and is a world first – it’s a very focused way of buying into the ‘picks and shovels’ manufacturers of the mining sector. The total expense ratio for the ETF is 0.69% and its underlying index is the ISE Mining Service Index.
It’s crucial to say, though, that my investment strategy of seeking out companies that will benefit from long-term growth in demand for mining engineers isn’t based on a market view that suggests that demand will head upwards in a straightforward exponential manner! Far from it, in fact. In my view this sector is due a thorough beating over the next few months. To take just one small example, let’s look at the fortunes of Joy Global Inc, currently the world’s largest maker of underground mining equipment and a major holding in the Pure Funds ETF. To say it’s having a bad time at the moment is something of an epic understatement!
Only a few months back, for instance, Bloomberg reported that it had “cut its full-year profit and sales forecasts and said it sees no immediate recovery in orders as commodity producers reduce spending amid surplus supply. Net income will be $5.60 to $5.80 a share on revenue of $4.9 billion to $5 billion in the year through October, the Milwaukee-based company said today in a statement. That’s lower than its February projection for per-share profit of $5.75 to $6.35 on sales of $4.9 billion to $5.2 billion. Joy posted second-quarter earnings excluding restructuring costs of $1.73 a share.”
According to Joy “The company’s customers have cut capital spending by 40 percent to 50 percent in response to lower commodity prices” with sales of new equipment down 33 percent in the second quarter, “driven by weakness in the US, where coal producers have struggled to compete as some power utilities switch to cheaper natural gas.”
And Joy’s troubles are far from being unique. Most of the big mining equipment manufacturers are having a tough time at the moment, with share prices crashing to the floor. Those fundamentals are telling us that investors are still overwhelmingly negative about the capex suppliers to the mining space. And who can honestly blame them? Currently, CEOs at large mining conglomerates are winning plaudits for slashing and burning their capex budgets, switching any available cash to paying down debts and increasing dividends – assuming that the dividend is still in place at all!
So the wider macro backdrop for the mining equipment companies is pretty god damned awful. And it could arguably get worse, if China slows down or more emerging market resource-focused equipment manufacturers use the current mayhem to undercut first world manufacturers? Surely won’t the big developed world, independent mining engineers go the same way as virtually all other first world peers – eaten alive by companies from places like China who can supply high-quality equipment at lower prices?
It all makes grim reading but I suspect that the commodity bears want their cake and eat it. They want to argue that commodity prices are set to carry on going lower and lower even while capex spending vanishes down a big black hole. Energy and resource intensity is dropping dramatically in the developing world, of course, which could help dampen down demand growth. But surely the commodity bears are missing one essential fact – namely, that countless billions of new customers in emerging countries are flooding on to the markets in the next decade?
They’ll want material goods and either there won’t be enough iron/copper/zinc to go around (surely good news for the owners of these resources) or there’ll be too much of it as supply ramps up. If the latter does come to pass, that surely must be good news for the mining equipment manufacturers? All that massive increase in supply will require colossal investment in new capacity? Alternatively if prices shoot up, then the large miners will boast fat profit margins, which they’ll need to use to improve productivity at their existing mines by spending on new capex?
Either way, I can’t see why demand will drastically decline for the major mining equipment companies over the long term. This is one grand narrative that I think has a direct investment opportunity attached to it. I have no doubt that the next 12 months will be very grim indeed but as surely as night follows day, sentiment will turn and suddenly investors will wake up and understand the bold statistics of sector-wide growth.
According to data from S&P Capital IQ, the top 10 miners generated $88 billion dollars in operating cash flow from 2001-2011, but recorded $89 billion in expenses related to capex and acquisitions. Two other pop-trivia facts: global mineral exploration expenditure has increased approximately 1000% over the last 10 years, whilst the estimated worldwide non-ferrous metal exploration budget for 2012 rose to $21.5 billion, up 19% from 2011, setting an all-time high.
And that surging multi decade demand has hardly gone unnoticed by the world’s leading engineering companies. M&A activity is on the rise across the sector. Two of the largest companies in the world have recently made significant investments in the mining service industry. General Electric this year announced the creation of a new division, GE Mining, which will buy mining equipment and service companies whilst Caterpillar last year bought surface and underground mining equipment maker Bucyrus International for approximately $8.8 billion.
Even Joy Global has received its fair share of market speculation about a takeover. Its CEO recently noted at a London investor conference that “Rumours [about a takeover] have come and gone and rumours will come and go…We work for our shareholders and are going to do the right thing for shareholders. Whatever third parties want to do, we will do the proper evaluation and make the right decision.”
Those comments sparked a Bloomberg article that observed that Joy Global’s “valuation has gotten more attractive,” according to Stephen Volkamnn, a New York-based analyst at Jefferies. “If you want to be in the global mining business, this is a way to bulk up in size pretty quickly. The stock is cheaper now, but the company is in good shape financially and margins are high”, he added.
And as for the emerging market marauders at the gates, I’d be cautiously optimistic about our developed world sector leaders. The German engineering industry has shown that anyone in the developed world can survive and prosper if they have the right combination of superb design, exclusive intellectual property, a reputation for safety and air-tight long-term maintenance contracts. I have no doubt that there are hundreds of smaller Chinese manufacturers looking to smash the companies that dominate this sector but although their price may be right, I’d be willing to bet that the big mining companies would prefer absolute reliability and high productivity over simple cost. For me, investing in mining engineers is one of those long-term stories that defies my own cynicism about grand narratives. And the good news is that, with the Pure Funds ISE Mining Service ETF, there may just be a fund that allows us to access the theme in a simple, direct way!
Top holdings – Pure Funds ISE Mining Service ETF (as of 28/08/2013)