For oil and mining companies, “it’s now value over volume,” the London-based co-manager of Investec Global Natural Resources Fund told FSA during a recent trip to Hong Kong.
“When we talk to the companies about capital allocation and corporate strategy, this is what we want to hear,” he said. “We want them to create value for shareholders, not just to build empires.”
“It was only about 14 months ago that people were saying some of the big mining companies are going to be bankrupt, and US shale companies are going to collapse,” he continued. “Since then, those companies have done a lot of asset sales, restructured, some of them [have] changed their management team.”
They have also changed the way they manage their finances. A key measure of the firm’s financial health is the leverage ratio in terms of debt to earnings before interest, tax, depreciation and amortisation (EBITDA), Nelson explained.
“These companies have learned that they need to think about EBITDA at different stages of the cycle,” he said. They are also more willing to share profits as dividends, he added.
One prominent example is Glencore Xstrata, which was heavily indebted and has undergone asset sales. Glencore’s London-listed stock price has now rebounded to £320 from the lowest £73.5 in January last year. At the end of February the company was the top holding of the Investec Global Natural Resources Fund.
The fund is now in the process of increasing exposure towards energy sector, already overweighted by 5%, noted Nelson.
Fundamentals for both mining and energy sector have been positive this year, he said. The firm forecasts the oil price to rise to an average $60 this year versus $45 in 2016 and $55 in 2015, as the OPEC cut will likely tighten the oil supply.
The sector’s performance, however, depends not only on commodity prices, said Nelson. “The companies are now more profitable and focused on generating cash flows.” It means they should be less volatile and more resilient if the oil price remains stable or falls, he continued.
The fund invests in commodity and natural resources sectors, with an approximate 40-40-20 split in energy, mining and agriculture companies.
The seven-people investment team starts with screening both the commodities and the stocks on factors such as supply and demand, momentum and seasonality for the commodities, and financial figures for listed companies: earnings, cash flows, return on equity (ROE), etc.
The second step is fundamental analysis, which will determine a target price and a risk score for a company from analysis of its income statement, cash flow and balance sheet.
“One of the most important measures is return on capital,” said Nelson. “We look for more stable businesses; we want to invest in companies that generate a higher return on capital through commodity cycles.”
When calculating a company’s risk score, the team looks at financial and operational risk, explained Nelson. The latter is used to discount the target price. A stock with a good upside potential and a low risk score would have a low overall upside. “We see that particularly [true] in emerging markets,” he added.
Nelson also highlighted the importance of Environmental, Social and Governance (ESG) factors. “Bad ESG in this sector destroys value,” he said. Events like an oil spill, poor safety measures for employees, or corruption can be disastrous for commodity and resources companies.
An example would be Petrobras, a state-owned Brazilian oil company which ran into a multibillion-dollar corruption scandal in 2014. Its stock fell 60% in 2014 and 2015.
The three-year performance of Investec Global Natural Resources Fund versus the FE’s average natural resources sector in the Hong Kong fund universe.