Warren Buffett aims to invest in real businesses, and he suggests we avoid those that offer ‘commodity-type returns’. But at Mine Insider, we are not so sure we should take this as a rigid rule – some of the richest people of all time made their fortunes from commodities, from Rockefeller to the Guggenheim family and Andrew Carnegie. Even in today’s tough times for mining, energy and metals, we suspect that the great mining investors/developers like Laksmi Mittal, a number of Russian oligarchs and Mukesh Ambani would argue that commodities can be the basis of great wealth. So is there something that ‘ordinary’ investors can learn from Warren Buffett and apply to mining investment?
It should be simple enough to make money from commodities: they are cyclical, the peaks and troughs are mostly obvious and, oddly enough, there are counterparties willing to sell assets at low prices when times are tough. At Mine Insider, we think two important conditions are now in place. Firstly, we think that metals and mineral prices are approaching the bottom of the price cycle (“it’s now time to buy into commodities – we may have hit bottom with recovery ahead”). Secondly, assets are for sale at low prices (see our post “The Great Mining ‘Liquidation Sale’ – time to buy distressed assets”). We think that some of these distressed assets can represent particularly good value, but you need to be highly selective. The challenge for retail investors is that they can’t buy mines, they are only able to buy shares in companies.
So today, we will look at how to invest in mining companies using the principles of value investing. This brings together two things we feel strongly about. We view mining as a valuable and potentially lucrative activity. We also think that value investing – as originally set out by Benjamin Graham and developed by his many followers, notably that great investor Warren Buffett – is a practical and effective guide to investment.
Of course, in a short article we can’t do justice to the rigour and extent of the value investing ideas, but please humour us as we lay out some simple principles we propose to apply.
At the core of value investing is establishing the intrinsic value of a company share which may be very different from its market value. Value investors are seeking companies with share prices trading at steep discount to their intrinsic value. Obviously, this is easier said than done. So you must also have the discipline to follow strict analytical guidelines in making decisions and the patience to wait for investment opportunities to arise.
Paraphrasing Jason Zweig in his foreword to the revised edition of Benjamin Graham’s classic “The Intelligent Investor”, the core principles of value investing are:
- A stock is “an ownership interest in an actual business, with an underlying value that does not depend on its share price.”
- The market “forever swings between unsustainable optimism (which makes stocks too expensive) and unjustified pessimism (which makes them too cheap).”
- “The future value of every investment is a function of its present price”.
- Only by “never overpaying, no matter how exciting an investment seems to be – can you minimise your odds of error.”
- “In the end, how your investments behave is much less important than how you behave.”
So while Mine Insider is not qualified to teach patience or discipline, we can suggest analytical measures for assessing whether a mining company represents value as an investment. The parameters we think are important include:
- Assess the extraction of reserves. You need to have some idea of the long term physical parameters defining the extraction of reserves (material movement, plant yield etc). Thankfully, the improvement in reserve and resource reporting for public companies make this task a little easier, but you still need to dig through the fine print of JORC statements or 43-101 reports. Long life, low cost reserves are great, but can be expensive. Opportunities in lower quality assets should not be overlooked – ultimately it comes down to the price paid for the mining company’s stocks. As Howard Marks says in Uncommon Sense for the Thoughtful Investor: “A high-quality asset can constitute a good or bad buy, and a low-quality asset can constitute a good or bad buy …. The failure to distinguish between good assets and good buys, get most investors into trouble.” At Mine Insider, there is one category we avoid like the plague, which is expensive mines with limited reserves that rely on assumed future resource conversion. Don’t value resources: if management has not taken time to convert resources into reserves, why should you as an investor take a gamble?
- Define your view of future costs. Low costs are ideal, as low relative costs may imply more resilience during the inevitable low points of the commodity cycle. This also may imply higher intrinsic value (all else being equal). But we prefer a well-managed business with high cost assets –which can still generate excellent long term returns – to a business with high costs assets that spends all the money rather than returning it to shareholders (see our post ‘$400 billion reasons why mining management must change’)
- Assess earnings at long term average prices and sustainable material movement costs. The volatility of minerals prices represents a special challenge in assessing the value of a mining asset or mining company. We suggest you ignore consensus forecasts as these reflect current perceptions (see out post “Prophesies, Oracles and Omens – why you should ignore single point forecasts”). Unless you have a particular view, we suggest you use the average real price over the last 20 years. Similarly, do not be taken in by short term costs – these can be affected by high-grading in the troughs or exuberance in the peaks – use sustainable average costs for material movement over the last three years.
- Choose companies with low debt. Given the volatility of commodity prices, Mine Insider prefers mining companies with low debt to equity and low debt to earnings. Debt and volatile prices are a dangerous mix in any industry, but especially in
- Consciously assess the board and management team. We look for a disciplined record in effective allocation of capital throughout the cycle combined with a track record of shareholder returns. An investor should also look for the board and management’s skills and experience in “consolidating” assets at the right point in the commodity cycle. Arguably, Mittal would fit this description or more recently, Bill Beament’s efforts at Northern Star Resources are another example.
Some would argue that mining companies really don’t sit within the value-investing framework because of instability of future earnings. Mine Insider disagrees. We acknowledge it is difficult predicting future revenue because commodity prices are inherently volatile. However, many facets of mining operations are predictable with high-levels of reliability. For example, production tonnage and costs from a well established mine with an experienced operations crew is predictable. Using a long-term real average price as the basis for future revenues is one way to avoid the difficulty of arriving at a reliable unbiased price forecast.
The bigger problem is that many mining companies do not make enough information available to make a balanced assessment. Our advice in this case is simple: don’t buy the shares if you can’t see the value. There is a big universe of potential investments, so you can afford to be selective. It is better to miss one or two good investments than lose money on many investments based on imperfect information.
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