Mining for a ROE revival

Has Australia’s decade-long love affair with mining equities finally come to an end?

This is arguably the most vexing question facing investors today as mining-related stocks, particularly those at the smaller end of the market, dominate the list of worst performers for 2012-13.

Slumping hard commodity prices, on the back of fears that China is facing a sharp slowdown in growth, is the primary reason why the relationship between miners and investors is on the rocks – prompting most experts to pronounce the mining boom “dead and buried”.

This definitive proclamation has contributed to a 49% collapse in the ASX Small Resources Index over the past year and a median 41.8% total loss in mining stocks on the top 200 stock index.

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No-one wants to dance with the bride of Frankenstein, but I suspect mining stocks could be the belle of the ball over the coming months.

A mining sector re-rating?

This may sound like a deeply contrarian call given that some high-profile experts are warning investors to stay away from the sector as they think metal prices have only one way to go, and that is down.

However, I believe the panic selling of mining stocks is being driven more by the deterioration in the quality of their earnings than by commodity prices.  Both may be related, but there is subtle but important difference between the two that will lend insight into a potential catalyst for a sector re-rating.

I looked at base metal and bulk commodity miners with producing assets that go back over the last decade (I left out gold miners to keep things simple) and found a marked deterioration in their return on equity (ROE) over the past two years, despite having reasonably high and stable commodity prices.

As the chart below shows, the average ROE plunged from 21.6% to a mere 3.5% even though hard commodity prices (as measured by the CRB Metals Index) have only corrected by around 15% since 2011.

ROE essentially measures the amount of profit a company makes for every dollar you invest in the company. Those with a high ROE are better regarded by the market, as their management team is able to maximise the use of capital.

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This is why there is a strong correlation between ROE and share price performance. You only need to look at the premium Commonwealth Bank of Australia (CBA) commands over the other big three banks to see the connection.

There are a number of reasons why the ROEs for mining companies are degrading at such an alarming pace, but one key contributing factor is poor strategic decision making. 

Sure, operating costs have skyrocketed, adding to margin pressure, but the average earnings before interest, tax, depreciation and amortisation (EBITDA) margin has not been hammered quite to the same extent as ROE.  This margin is down by around a third.

This to me indicates that the drop-off in the quality of mining profits is not tied so much to operational issues but decisions taken at a corporate level.  These could include badly timed new projects, mine expansion programs and acquisitions.

While this conclusion may not surprise, at least now you have some way to quantify this strategic factor, which leads me to my next point.

Lifting ROE

If mining managers can lift ROE, we will likely see a re-rating of the sector, and I suspect there is a good chance this will happen in the near future.

As reported in Eureka Report on Friday, BHP Billiton (BHP) is copying CBA’s strategies in order to generate stronger returns for shareholders, and other large miners are following suit.

Stand by for a big bounce in ROE. The average ROE of established mineral producers stands at a little over 8%, but if management is diligent about focusing on shareholder returns ROE for the next periods will likely exceed the average, even if commodity prices were to fall further.

I say that because these miners were able to generate near-record ROEs back in late 2004 when commodity prices were around half where they are now. If you looked at return on invested capital (ROIC), which can’t be bolstered through the use of debt like ROE can, it would paint a similar picture.

Credit Suisse strategist, Damien Boey, isn’t quite ready to be a mining sector bull, but he believes the stars are lining up for a mining equity run-up.

“At the very least, I would say you shouldn’t be shorting the larger lower-cost producers because the valuations have priced in significant bad news,” says Boey.

“On our measure of mining valuation, miners are something like 46% undervalued compared with Australian dollar commodity prices.”

He also believes China could embark on a stimulus program as its economy decelerates. The drop in China’s official purchasing managers’ index to 50.1 for June, compared with 50.8 in the previous month, is adding to this expectation and any stimulus announcement is likely to trigger a rally in the resources sector.

Boey says Credit Suisse could potentially be recommending investors go overweight on the larger miners in the coming months.