Investors go mining for higher yields

Summary: The relentless hunt for yield by investors has turned back to the mining sector. Cashed-up companies such as BHP, Rio and others have delivered good fully franked dividends from their latest earnings.

Key take-out: Based on latest share prices large mining companies appear to be almost as attractive as the big banks when it comes to yield. But investors need to question how long the dividend flows will last.

Mining companies are enjoying a revival, with potential investors seeking higher returns than bank deposits offering 2 per cent and bank shares yielding between 5 per cent and 6 per cent.

Why not, goes the theory, be satisfied with BHP on a dividend yield of 4.4 per cent, or Rio Tinto on 4.6 per cent? Both stocks appear to be on track to generate significantly higher cash flows over the next few years thanks to higher-than-expected metal prices, and lower-than-expected costs.

Moreover capital requirements to build new mines will not be high for some time as the wave of developments undertaken in the last boom is only just reaching full production levels.

So rather than investing in new projects it is considered likely that shareholders will be showered with cash in the form of higher dividends, which will further boost yields, or share buy-backs which will boost share prices.

As a theory it makes perfect sense, except for investors who have memories that stretch back just 25 months.

BHP's slump: A quick recap

In August 2015 the chief executive of BHP, Andrew Mackenzie, made his famous comment about the company retaining its so-called “progressive” dividend, a concept built on an assumption that the annual payout would never be reduced.

“Over my dead body sounds a little strong but it's almost right,” were the words used by Mackenzie to predict no change in dividend policy. The forecast lasted less than six months when low commodity prices and a devastating mine accident in Brazil shredded the company's financial performance and share price.

At the time of his comment, which he doubtlessly regrets, BHP shares were trading at $25.50. By the time the dust settled and the dividend cut was made, they had fallen by 40.8 per cent to $15.10.

In fact, the collapse in BHP's share price started long before the final slide in late 2015 because a year earlier (August 2014) the stock was trading at $39.

What happened to BHP between that 2014 high and the infamous “over my dead body” remark is that a lot of investors ceased to believe what the company was promising.

The best way of testing unbelief is to look back at the yield being commanded by BHP shares at the time of promising a dividend. It was a whopping 8 per cent, which was higher than that on offer from the banks.

The BHP yield in 2015 was an unmistakable warning sign that either the BHP share price had to rise, or the dividend had to be cut. By early 2016 it was both: dividend down and share price down.

Mining and lucrative yields

Based on their latest share prices big mining companies do appear to be almost as attractive as banks when it comes to yield. One of the best illustrations being the narrow gap between BHP at 4.4 per cent and ANZ Bank at 5.4 per cent – both 100 per cent franked.

This time it might be different, though older investors know that it never is, and investment banks can't resist dusting off their research into miners as cash cows or champion dividend stocks.

UBS, in a report circulated last week, returned to the theory of miners as dividend/yield plays under the heading: “How much cash can the miners return by end-18?”

The answer varied from company to company, with UBS preferring Rio Tinto, BHP and South32 for their strong free cash flows.

The key element to the bank's calculations is the uplift in cash flows from combining higher commodity prices and lower costs after metal prices slumped between 2012 and early last year.

This mix of good luck and good management means that most big miners will be in a position to richly reward shareholders over the next 18 to 24 months, until the need to invest in new mines takes precedence over investor returns.

“Investors have historically bought mining companies for growth not yield, given the finite nature of their assets, which requires the miners to continuously invest in new mines to sustain operations,” UBS said.

“So, while miners may not have the stable cash flow stream of an industrial company, and thus may not be able to sustain high payout ratios, we do see the potential for the miners to provide high returns for investors over the next 18 months, perhaps longer.

“Inevitably, we believe the call to invest or acquire will become too strong and the industry will follow the path of prior cycles, but until that happens we believe the sector is poised to return a substantial amount of cash to shareholders.”

With copper at $US3 a pound, gold at $1650 an ounce, and iron ore at $US75 a tonne, the outlook for mining companies has rarely looked better – especially as they have all driven costs down significantly.

Whether the high commodity prices can be maintained, and inevitable cost pressures curbed, it is the judgement call required of investors.

The optimistic case is that a window of cash flow opportunity has opened and could remain open for the next 18 months to two years.

The pessimistic case is that the cash flow window might only be open for the next year, while the ultra-pessimistic view is that it could slam shut as abruptly as it did on Mackenzie two years ago.