Originally published by UBS Asset Management
Our portfolios have been underweight miners for all but two of the last 16 years. Early in this period the active position was narrower as valuation opportunities in resources were greater in the earlier underappreciated stages of China's commodity intensive growth. However, as the sector outperformed, China's demand for resources matured, supply increased and Chinese policy tightened, the risks around investing in the space increased and the underweight expanded from 2009. Since then resources have underperformed by over 50%, even after last year's bounce.
Over the last 10 years, share price performance has been highly correlated with spot commodity prices which in turn are driven by Chinese policy. Therefore, whether the Chinese authorities are enacting stimulatory or tightening measures, is driving performance.
The bounce the sector experienced in 2016 was clearly generated by the release of pressure on Chinese monetary conditions. While this may have coincided with some depressed conventional value metrics, without the combined impact of a huge budget deficit (largest in at least 25 years) and more importantly the withdrawal of mainly coal supply, the appearance of improved value which repeatedly emerged over 2011, 2012, 2013, 2014 and 2015 during which the resources index underperformed by -100%, could have remained a value trap. Capitulation however by fund managers now appears complete with miners apparently a consensus overweight.
Using Porter analysis, the sector rates poorly. Buyer power particularly in bulks is huge, commodities are obviously very substitutable and rivalry is constantly fierce. Our low conviction in the space requires the relative valuation opportunity to be far greater. This is due to risks (short and long term) including:
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uncertainty around the true sustainable level of commodity demand given current artificial inflation
- commodity prices remaining well above mid-cycle, incentive or company budgeted levels
- industry margins are at historic highs
- Increasingly unsustainable and ineffectual Chinese stimulus (more and more debt required to generate less and less growth)
- inventory levels for the iron ore bell weather being at historic highs
- Chinese economic and steel authorities calling a peak in steel production and prices
- policy in China being tightened again (in some cases barely 6 months since the stimulus began)
These make it difficult to determine the sustainable cash flow generation of these companies to value. Price to book is irrelevant if oversupply collapses returns as book values will be proven to be inflated. Benchmark weighting assumes the rest of the market operates in a vacuum and the outlook from now is similar to that a decade ago.
This doesn't mean we've given up on investing in volatile or commodity industries. We made money in steel before and remain overweight energy where we retain conviction around earnings given strong stock specific growth projects, more reliable demand and ongoing geological supply challenges despite the emergence of shale. It just means that in addition to an attractive relative valuation, we require conviction in the fundamental underlying economics (stock specific, industry or macro) to invest client capital.