Hangover ahead for Miners?

Hangover ahead for Miners?

Recently a 5.5kg gold nugget was discovered prospecting around an old mine in Ballarat. Sometimes lightning strikes twice but more often trying to repeat past successes is like a dog returning to its vomit.

Spare a brief thought for the hapless long-term investor in businesses with sustainable competitive advantages. Sadly, these are not the businesses the stock market has been enamored with over the past six months.

The 76 companies that make up the mining services sector have significantly outperformed the broader benchmarks, including the ASX 200, over this time. Unlike our previous and very profitable activity in the space however, we made a conscious decision not to participate this time.

Prior to embarking on the annual Christmas pudding binge, the market pursued a binge of another type – buying into those companies that cannot control the prices of the products they sell, nor defend their margins in the face of excess capacity. These businesses are in the iron-ore mining and servicing space and a rally in the price of iron ore to US$145/t reignited the fad.

The best business to own is the one that can continue to charge higher prices for its product or service even in the face of excess supply. Mining businesses are the antithesis of this and while short term gains in their share prices leave us wishing we had been a follower, the reality is that over the long run, you will still do well avoiding their cyclicality.

While several mining services company share prices have rallied from $1.00 to $2.00 recently, one needs to be reminded that they have also fallen from $4.00 earlier in 2012. Over a longer period of time, 12 months, these same businesses have materially underperformed the ASX 200.

Having profitably reduced our position in mining services back in March and April 2012 before they slid up to 60%, we do not believe that success can be repeated.

Our view is anchored by recent meetings with the management of a number of leading mining services business. A few a points worth considering;

· Margins across the board are likely to fall – industry wide profit margins have been very high reflecting a constrained market however slack is forming in future work pipelines,
· Growth in order books will be less predictable, harder to achieve and a ‘steady-state’ harder to manage given lower frequency of contract wins,
· Success in achieving business strategies is a much riskier proposition given larger dependence being placed on the winning of fewer and larger contracts, and
· Lower utilisation rates are notable and are continuing.

Its also worth noting as an indication that momentum is slowing; Labour markets and union pressures have eased significantly in this mining services sector.

What we have taken away from our meetings is that mining services businesses will show great results for the first six months of FY2013 and even for the full year given past contract awards, however, there is ‘slack’ developing in project pipelines which is causing the downward pressure on labour markets and unions – hence the outlook is less sanguine.

Looking into 2014 we see a highly competitive tendering environment (lower margins) as the sector shrinks from historically high percentages of GDP to a smaller quantum of larger contracts. Only the highest quality businesses with long-established relationships will win. Profit margins will fall as tender prices are lowered to remain competitive hence even if order books and revenues are stable, profitability will not be.

We are always prepared to be unpopular for a long period of time as the latest market fad runs its course. While we may miss another 20%-30% rise in the share prices of mining services business, we feel that the easy days of 2000 – 2012 are well behind us. The recent rally in iron ore may simply be a “head-fake” and new lows in iron ore prices this year are quite possible.

Sure, we won’t be popular but over the very long run great returns are what we are after and we can get those by remaining invested in businesses whose 2013 earnings are already ‘in the bag’ along with 20-30% profit growth. And so the approach advocated and practiced at Montgomery should produce returns ahead of the broad indices – fads notwithstanding.

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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.