Investors likely to be tempted by the current prices, yet commodity producers are price takers and cannot be relied on to grow profits ahead of the market over long periodsIn 2018 mining shares were one of the few places to hide, offering the only double-digit returns in the FTSE/JSE Top 40 Index. Yet we have been reducing exposure to this sector, with mining shares now comprising less than 8% of the PSG Equity Fund, compared to 14% early in 2016.
To make provision for these risks, it’s important to focus on ensuring a sufficient margin of safety and to place increased emphasis on valuation. Since macro-economic data — and particularly future demand — is unpredictable, commodity prices can’t be accurately forecasted. Instead, we focus on understanding the long-term capital cycle for a commodity and what it suggests for the sustainability of prices, whether high or low.
Pro-cyclical capital allocation has tempered shareholder returns over the past decade-and-a-half — a period of booming commodity prices and rapid growth in demand from China. An assessment of Amplats’s management and their capital allocation decisions shows that they started taking steps to improve the quality of earnings and the balance sheet as far back as 2012. Though many of their decisions were unpopular at the time, they’ve steered the company away from exposure to narrow, steep and labour-intensive ore bodies towards higher-quality assets.
As most market participants focused on the unsupportive environment for platinum, they overlooked the favourable outlook for palladium. A deficit in palladium had resulted from insufficient primary production and wider global enforcement of stricter emissions standards, as its primary use is in light-duty petrol vehicles.
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