‘Not sustainable at all’: Investors stockpiling miners in spite of soaring share prices

It feels like a lifetime ago, but only five months have passed since investors thought Canada’s two biggest copper miners were at risk of collapsing.

In mid-January, Teck Resources Ltd.’s long-term notes traded as low as 38.5 cents on the dollar. Meanwhile, the debt of First Quantum Minerals Ltd., one of its chief rivals, traded between 40 and 45 cents. The mining industry was drowning in debt and the market feared that big-name companies were heading for painful restructurings, if not outright failure.

It’s easy to see where that kind of thinking came from. Commodity prices were plummeting, and most experts thought they were going nowhere for at least the next few years, possibly the next decade. Stock prices across the mining sector were at multi-year lows, and investor sentiment on the sector was arguably the worst it had ever been.

It is a different world today. Nearly every significant mining stock has doubled, tripled or quadrupled from its mid-January low. The debt concerns, which were front and centre over the winter, are long forgotten. Money has been raised across the sector — even some of the micro-caps on the long-neglected TSX Venture Exchange managed to get their hands on cash.

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The sector’s stock performance has been simply incredible. Every one of the top 10 performers on the S&P/TSX Composite Index so far in 2016 is a mining company, as are 17 of the top 20. It is a complete reversal from 2015, when the worst performers were all mining and energy firms.

The initial bump in January and February was not surprising since the stocks were absurdly cheap and a relief rally was inevitable. But many onlookers have been stunned at how they have continued to rise over the past several weeks.

Now the industry is facing a new, albeit less problematic concern: That the rally is completely overdone, and there will be a lot of pain to go around once the euphoria runs out.

One red flag is that mining stock prices have vastly outperformed the underlying commodities. Metals such as gold and silver have strongly rallied from their January lows, but others are up only modestly. Copper and aluminum, for example, have gained about 11 per cent each.

Some equities now appear to be priced based on significantly higher commodity prices.

Experts do not think these commodities are about to bust out: supply is ample, Chinese demand remains wobbly and the Brexit crisis has boosted global economic uncertainty. The one big factor working in favour of commodities this year has been a weakening U.S. dollar, and even that has rallied since the Brexit vote.

The rally is not sustainable at all

The days of China growing 12 per cent a year are also long over, and the general feeling is that gains in industrial metal prices are likely to be far more modest than they were a decade ago.

As a result, the calls for a correction have become louder as the stocks move higher. Teck now has more sell ratings than buy ratings from equity analysts, which almost never happens in Canada’s cozy brokerage world for any company not heading to zero.

“The rally is not sustainable at all,” said portfolio manager John Stephenson, who runs his own asset management firm in Toronto.

“If you’re an investor, you have to ask yourself, ‘Why won’t these go down?’ The fundamentals haven’t changed, and the commodity prices are likely to move down because there’s too much capacity.”

Stephenson shares the prevailing view that the sector’s rally started because equities were oversold and priced in the risk of bankruptcy (which was never going to happen). But now he thinks they factoring in big gains in commodity prices, and he doesn’t see how those will materialize.

“You’ve got banks trading at a discount, and metals companies trading at a premium to their (net asset value). It makes no sense,” he said.

Independent mining analyst Terry Ortslan noted another factor behind the rally: after all the industry consolidation of the past 15 years, there simply aren’t many quality mining stocks to invest in. Once the sector rebounded, the remaining ones were bound to attract a lot of capital and post huge gains.

“There’s no surprise Teck moved up by a factor of four, and First Quantum the same thing,” he said. “The market is not looking at the price of copper. It’s looking for the next momentum generator.”

THE CANADIAN PRESS/HO, Teck Resources

THE CANADIAN PRESS/HO, Teck ResourcesA truck hauls a load at Teck Resources Coal Mountain operation near Sparwood, B.C.

Ortslan added that the industry continues to suffer from a number of entrenched problems that haven’t gone away: high taxation, lack of new discoveries, permitting challenges and the virtual disappearance of M&A premiums. Put together, he does not expect this rally to last much longer.

But others disagree. For one thing, there is increasing confidence that January really did mark the bottom after a brutal four-year bear market. Commodity demand remains relatively stable, and supply will come under pressure over the next decade as the industry finally pays the penalty for years of under-investment.

This dynamic is already happening in zinc, which has outperformed other base metals this year as old mines have closed and not been replaced by new ones.

And equities still look affordable on some metrics, experts said. Ian Nakamoto, director of research at MacDougall, MacDougall & MacTier Inc., said Teck was trading at 15 to 20 per cent of replacement value at the bottom of the market. Today, it still only trades at about half of book value, he said, adding that it has traded far above book value during previous stronger commodity price environments.

“It’s fair to say the worst is over for these natural resource companies,” he said. “A major retracement in commodity prices seems unlikely barring recession, and I don’t think a recession is very likely.”

Only a minority of investors think base metals equities are a screaming buy at this point, but a far greater number remain convinced gold stocks are going higher, despite this year’s stellar performance.

Gold prices have soared 25 per cent in 2016 as the U.S. economy weakened and the Federal Reserve turned skittish about rate hikes. Brexit, of course, has only boosted gold’s appeal as a safe haven.

Shares of the big producers such as Barrick Gold Corp. and Kinross Gold Corp. have more than tripled from their lows, but they still trade at multiples far weaker than they did a decade ago.

The gold bugs argue that gold is going higher forever and the stocks are always a screaming buy. But bullish fund managers are making a more reasonable argument today: quite simply, these stocks remain incredibly under-owned by investors.

It’s fair to say the worst is over for these natural resource companies

Jason Mayer, a senior portfolio manager at Sprott Asset Management LP, said gold stocks made up 7.7 per cent of stocks in the S&P/TSX Composite in the first quarter, but drove 40 per cent of the index’s overall return. He figures generalist investors have zero to one per cent of their holdings in gold, so they barely participated in the upswing.

“We know the generalist is nowhere near market weight in gold. So they’re underperforming the benchmark,” Mayer said. “When the generalist says, ‘I need gold exposure and I don’t care at what cost,’ it drives (net asset values) higher.”

More broadly, it is easy to forget how little base and precious metal mining stocks are worth today compared to their peaks in 2011. Even after the incredible gains this year, Barrick is down more than 50 per cent from its high, while Teck is down 75 per cent.

The companies themselves are also much stronger than they used to be, experts note. Over the past few years, miners have implemented major cost cuts and debt reduction measures. As a result, they are generating much more cash at current metal prices than they would have at the same prices a decade ago. They can easily withstand another drop in prices, and they benefit more than ever if there is an upswing.

An ugly correction may well be on the horizon for the mining sector. But the last five months have, at the very least, provided assurance that no major company is on the brink of collapse. The panic is truly over, even if the euphoria doesn’t replace it for too much longer.

Financial Post

pkoven@nationalpost.com

Twitter.com/peterkoven

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