Mining services: don’t pick bottoms
If you lose 50 per cent of your funds, you need to make a 100 per cent return – speedily, on what you have left – just to get back to square one.
This rather unlikely subsequent return motivates us to preserve capital by avoiding losses wherever possible. Irrespective of the yield of a stock or the tax that we might be required to pay, it is better to avoid a material loss where it eventuality is obvious to us.
The current malaise in mining and mining services has been an example of an entirely predictable end to the resources boom. We have written about this malaise transpiring since 2011 and spoken about it on radio and on TV, and in fact, a year ago in June 2012, we were warning investors to ignore the expert and self-interested prognostications about the prospects for mining and mining services.
Take a look at this video at the 2 minute mark.
And more recently, take a look at this video from 27 February 2013, at the 1m35s mark.
The point is that what is now transpiring has been relatively obvious. As an aside, the fact that we picked this particular turn of events does not qualify us for crystal ball status. It is merely an example of the benefits that can occur when portfolios are adjusted in advance of those events and themes, within one’s circle of competence, that do indeed become obvious.
Back to the present, and the optimists are suggesting that value is now emerging in mining and mining services stocks. As Table 1 reveals, there has certainly been a substantial de-rating as companies have clarified their expectations for business conditions.
The bulls suggest that iron ore volumes will rise, and that a falling Australian dollar will result in increased mining activity. They dismiss the possibility of dramatic falls in commodity prices and they dismiss a sustained collapse in capital investment. Given the Bureau of Resource and Energy Economics is now suggesting a 75 per cent decline in mining capital expenditure will eventuate between now and 2017, I would suggest that it is only strongly rallying commodity prices that will rescue the leaking boats.
True, the yields of some of the companies listed in Table 1. are attractive, their balance sheet strength and both their historical and current forecasts for return on equity all indicate there are high quality and well run businesses in the space.
Even the scans we run using Skaffold, and our multiple other processes, produce lists of companies to investigate with mining services companies at or near the top. But value traps loom large in the mind of experienced investors and given the deteriorating outlook, we ask: why run through a mine field? Our job is to protect and preserve our investors’ capital and simply ‘step over the one foot hurdles’ – the easy and obvious investments.
Even the good companies with bright prospects sometimes surprise us on the downside, so we don’t need to be risking your life savings playing chicken amid a field of exploding landmines. Why risk losing 50% for the hope of making 50%. The math doesn’t stack up.
Of more interest to us is the very real value that will emerge in discretionary retail companies. The rally in their share prices from the middle of last year had removed them from our lists of quality-at-value. That is all changing now. As investors panic about the weaker consumer sentiment and its impact on retailers, their prices will be sold off aggressively. Irrational selling doesn’t occur very often but when it does it helps to be prepared. This is why we have 45 per cent cash in The Montgomery [Private] Fund.
Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.
This post was contributed by a representative of Montgomery Investment Management Pty Limited (AFSL No. 354564). The principal purpose of this post is to provide factual information and not provide financial product advice. Additionally, the information provided is not intended to provide any recommendation or opinion about any financial product. Any commentary and statements of opinion however may contain general advice only that is prepared without taking into account your personal objectives, financial circumstances or needs. Because of this, before acting on any of the information provided, you should always consider its appropriateness in light of your personal objectives, financial circumstances and needs and should consider seeking independent advice from a financial advisor if necessary before making any decisions. This post specifically excludes personal advice.
dry hire
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Just wanted to say well done! I am very impressed :)
mark
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Is there a historical correllation between a falling GDP and a rise in discretionary spending ?
Julian Watt
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Why doesn’t Skaffold reflect your view on mining services? Surely that should be remedied.
Roger Montgomery
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Hi Julian,
Our views are our views. We use Skaffold to provide us with a list of companies to do more research on. Take a look at historical quality scores and you will see that they change. They will change in the future too and we believe they will deteriorate when they are forced to lower margins. That is not evident yet and so it remains just our view. Keep in mind we could be wrong.
Julian Watt
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Hi Roger
Thanks for the reply. I understand. Is your view taken into account as one of the “analysts” views on future earnings etc? Skaffold has worked really well for me, however, I have come to learn that I need to add a fair bit of my own research on possible future developments that might impact on those companies. I guess that means that indicators such as future intrinsic value and future EPS are not necessarily that reliable.
Roger Montgomery
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Well done! You must know the business you are seeking to own.
anthony.scelzi
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Confucius say “In stock market, man who try to pick bottom get smelly finger”.
xiao fang xu
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One need not know the exact weight of a man to know that he is fat or the exact age of a woman to know she is old. Benjamin Graham.
marklehuray
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There is two side to the mining services story.
In general the above article is basically sound.
However a slowdown is not necessarily a bad thing for all mining services companies.
Those with plenty of cash are well positioned to secure other business at a discount as a part of an inevitable consolidation in the sector.
Further all capex is not going to disappear overnight and the predictions for the next year or two are still historically high so there is still plenty to be made in the short term and even in the medium term the current capex projections are probably understated.
And of course you have to look at what area of mining service most of the revenue is derived from as all areas are not equal. Those with more exposure to long term maintenance contracts or oil and gas are probably much better positioned to maintain strong revenue streams.
FGE are a great example of an undervalued mining services company who with a big bag of cash has just bought another company with forward contracts in the maintenance area. It looks like a good buy without having done a real crunch on the numbers and further to that they still have 150m in cash for any further acquisitions and an order book now of well over 1 billion going forward for the next two years.
Roger Montgomery
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ANd that is what makes a market.
shem watson
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Hi Roger, Speaking of discretionary retail companies, what do you think of the reject shops prospects?
alex.baker.3745496
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I’ve got some questions.
If a mining services company has been providing an excellent “service” to their mining customer, just how easy is it for the miner to churn? And aren’t we all assuming a 100% churn rate? What if this rate eventuates to more like 10-15%. A well run mining services company just may have a competitive advantage in negotiations, in in fact it just might be darn well difficult for the miner to change service companies. I have no idea, because I don’t work in this industry, but in others I know changing contractors is actually quite difficult. Many people are assuming things that frankly they know nothing about. Have any of us actually sat around a big miner’s board room table in such negotiations? Seems to me the miners are now utterly dependant on many of the better run mining service companies. My guess is they would find it near on impossible to run without them. They are dependant on labour training, hiring, expert knowledge, IP, etc etc etc ..all of which is a large cost to churn is it not?.. Aren’t we all assuming a high churn rate? What if this actually doesn’t eventuate? . Sure, commodity prices might fall dramatically, and the incumbent service company might have to drop it’s charges…. but by 50%? Because isn’t this the sort of figure the market is pricing in? What if it’s more like only 10-20%.. What if a particular mining service company derives the majority of it’s income from the maintenance of mining? Ore and gas prices might fall of a cliff, but isn’t it possible volume may well continue at present levels? Just some “what if” contrarian questions. I genuinely have no idea of the answers. But is it possible neither does the market? Because the way the miners operate with all this contract labour has never been tested before during an equivalent downturn.
David S
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There are many types of mining services businesses. Some are required on an ongoing basis to run operations and others are there for one-off project activity. The issue is not that they are churning from one to another, its that the capex spend on projects is drying up due to weaker prospects in the sector. Even contractors who provide day-to-day services on existing mines are being laid off because the mines are no longer profitable or part of the “core” operations of the big multi-nationals. In the past they were able to take big margins on the work being undertaken because there was so much of it around, but now they are having to fight amongst each other to be the lowest bidder.
BHP has provided some commentary to the market which indicated that too much was being spent on contractors during the “mining boom” and that those expenses now need to be reined in – in a weaker environment. I think companies like BHP are looking to potentially take some of this stuff back in-house as wages growth in mining services has been well above system, or they will look to be much more aggressive in their pricing of contracts going forward. The writing is on the wall for the big miners because technically their shareholders should have been banking massive windfalls and their share prices should have been appreciating during the “boom”, however it would appear that only the mining services businesses prospered and passed on increased capital intensiveness to the miners. To most shareholders of the big miners, this is an unacceptable situation. Just look at what a lost decade it has been for Rio Tinto for example – there is little to show for the so called riches that our current misinformed Treasurer used to talk about.
What a lot of the mining services businesses do is not rocket science either – quite often its just turning dirt. One of the most expensive parts of the Olympic Dam development was just removing a kilometre or so of topsoil above where the ore body sat. It costs the Mining Services businesses $200-300k p.a. to hire the guys to shift this dirt and then they have to make a profit on top of that. To compare, the average miner in the US lives within a few kilometres from site and earns $39k p.a.
There are a number of reasons why Miners turn to Mining Services businesses rather than employ their own here, but the main reason tends to be that it gives more flexibility – there is no obligation to pay these people on a full time basis, pay redundancies, deal with unions and strikes, deal with governments and employment legislative change etc. – all the things that are strangling productivity in Australia at present. Only a few of the mining services businesses have truly unique and marketable IP. Mineral Resources is possibly the best example as they have a patented method for crushing wet haematite ore. Strangely enough, it looks like the only mining services business with a rising intrinsic value in Skaffold at present. The miners are going to have to mine more ore at a lower rate of profit to sustain current profit levels, so hence more crushing services needed – food for thought.
zoran arnautovic
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HUNTING/Mining services
Early this morning I got up determined to get me mining service or two.
I loaded up with cash and walked into the mountains looking for them. I was alone for few miles and was wondering:: why isn’t anyone else hunting.
It was misty but I could see 5 men in distance sitting down, their guns loaded.
I’m not quite sure but they looked like Roger,David,Tim,Russel and Ben.
Someone said: lets move and get a mining service or two!
I could have sworn I heard Rogers voice say: Not yet, we won’t chase them, let them come to us and we’ll get one by one then.
It was misty and I could have been wrong, anyway I proceeded and got me a couple .
Cheers
Zoran
Roger Montgomery
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Maybe more like a minnow fishing in a bath with the plug pulled out! ANd best wishes to you.
Andrew Legget
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If your a company that relies on the macro environment of a specific industry you will subject to the ebbs and flows of that industry. You could be the greatest mining services company ever created but if demand for services from the miners stop because of economics than you will have to sit on your hands and wait meaning some poor years.
I think the mining slowdown will leave a lot of people exposed when the tide goes out as that was the area everyone focused on. Don’t have foxtel anymore but when i did and watched sky business YMYC all the questions were usually regarding some exploration company. The answer consistently given to a person talking about investing was simply “buy BHP”.
You have warned us all consistently for quite a while Roger, we can only hope some people take a step back and realise that China can only use so much iron ore.
They may be few and far between, especially the cheap ones, but there are better companies in better industries out there. If you spread your net wider to include international markets there are many more.
The end of the mining boom will affect a lot of companies, and many that people wouldn’t even realise. Better to focus elsewhere than trying to play the timing game.