What has happened?
The metals & mining sector has been amongst the worst hit sectors amid the recent market volatility relating to the COVID-19 pandemic. This has always been a high beta sector exposed to global consumption, and it has once again proven thus. As at 20th March, JP Morgan calculated that since COVID-19 risk premia emerged in mid-January, European mining equities had decreased -39%, only modestly outperforming the Oil & Gas sector (-48%) and Airlines (-47%) . Fast forward ten days and the situation remains broadly similar.
Looking at spot commodity prices; copper, nickel, lead, zinc and aluminium are all trading at or near multi-year lows. Iron ore has proved surprisingly resilient, currently trading at $82/tonne, some way above its 12-month low of $72/tonne. This is on the back of limited supply, robust demand from China and increases to inventories. Nevertheless, Rio Tinto and BHP Group, which both have significant earnings exposure to iron ore (72.8% and 59.0% respectively at their recent FY and Half Year updates), have seen their share prices move ahead of the spot iron ore price as part of a significant de-rating. The wider metals & mining sector is now trading at c. 3x earnings (based on EV/EBITDA*) versus an average of 4.6x in 2018-19 .
Potential Economic Recovery?
Although there is still likely to be further equity market volatility over the coming weeks and months; following the momentous and wide-ranging policy measures implemented by governments globally and central banks, investors are now increasingly focusing on how and when the global economy can recover from the COVID-19 induced setback. The emphasis over the coming weeks will centre on the effectiveness of the lockdown measures, implemented in Europe and the US on the spread of the virus; whilst close attention will be paid as to how quickly the Chinese economy can get back on its feet. Our base case is that the global economy, aided by the unprecedented levels of stimulus, can begin to stage a recovery in the second half of this year.
Opportunity for the Mining Sector?
At this juncture, it is important to remember that during periods of economic resurgence the mining sector has a track record of delivering extreme share price recoveries. Looking back at what happened post the Global Financial Crisis (GFC) in 2008/9 and the China global growth scare in 2016; in each case, roughly 12 months after troughing the European Mining Index had appreciated in excess of +150% . On both occasions, significant liquidity injections into the global economy saw commodity prices strengthen over the following months. Certainly, the exact situation this time round is different, not least with the unprecedented COVID-19 isolation measures proving extremely disruptive to economies. However, it is highly likely that government responses in China and globally will include multi-year commitments to build & improve infrastructure, and this demand can support the sector for a prolonged period.
There are further incremental positives for the sector this time round that give us a greater degree of confidence. Firstly, following several years of disciplined capital management, the general health of companies in the metals & mining sector is markedly enhanced versus history. Crucially, most companies within the sector have robust balance sheets with relatively low levels of debt which means that, even at lower commodity prices, the highest quality would not need to implement damaging equity raises to stay funded. For instance, Rio Tinto and BHP Group both have Net Debt to Earnings ratios (based on Net Debt/EBITDA*) of under 0.5x at current spot prices, or c. 1x if commodity prices were to fall a further -20% . Should production be curtailed whilst mines are closed due to COVID-19 isolation measures, this balance sheet strength will also provide some protection.
Secondly, the mining sector looks an attractive proposition from a dividend perspective, both on a relative and absolute basis. Most diversified miners have pay-out ratio-based dividend policies which give them better flexibility to manage cashflows than some other income heavy sectors. For example, Rio Tinto has a commitment to pay-out 40-60% of underlying earnings across the cycle . As such, the miners are not committed to maintaining onerous dividends that could be detrimental to their financial health; whilst their earnings are forecast to hold-up better relative to other income orientated sectors such as financials and oil & gas. Furthermore, in the case of BHP Group and Rio Tinto, most of their operations are in the bottom quartile of the cost curve, which ensures both businesses can generate healthy free cash flow yields even if commodity prices move significantly lower. Based on current spot prices, BHP and Rio Tinto offer yields of 8-9% and 4-5% even if commodities fall -20% .
Finally, another potential benefit for the mining sector is that China, where COVID-19 originated, is likely to be at the forefront of the eventual global economic recovery. China accounts for up to 50% of global demand of commodities including copper and steel (which requires iron ore to manufacture) and as such, the health of the Chinese economy is vital to maintain a favourable demand backdrop for the mining sector. There are initial signs that China is starting to control the virus and is making progress towards re-establishing normal economic activity. To this end, the latest Caixin China Manufacturing PMI rebounded nearly 10 points to 50.1 in March, up from the record low of 40.3 in February . However, some caution is needed in interpreting the PMI data and this latest data point suggests stabilisation, rather than a full recovery.
To conclude, we are reassured with regards to the stability of companies within the metals & mining sector during the ongoing COVID-19 induced global economic shock and believe the sector can be at the forefront of the global market recovery when this starts to play-out. Nevertheless, for the time being, with the virus infection rate yet to peak in the western world, the focus remains on cautious capital management and downside protection.
*EBITDA Earnings before interest, tax, depreciation and amortization (EBITDA) is a measure of a company's operating performance. Essentially, it's a way to evaluate a company's performance without having to factor in financing decisions, accounting decisions or tax environments.
EV/EBITDA is a ratio that compares a company's Enterprise Value. It looks at the entire market value rather than just the equity value, so all ownership interests and asset claims from both debt and equity are included.
Net debt/EBITA ratio is a measurement of leverage, calculated as a company's interest-bearing liabilities minus cash, divided by EBITDA.
 JP Morgan European Equity Research, ‘EMEA Metals & Mining’, 20th March 2020.
 Bloomberg Data, as at 1st April 2020.
Please remember investment involves risk. The value of investments and the income from them can fall as well as rise and investors may not receive back the original amount invested. Past performance is not a guide to future performance.
By necessity, this briefing can only provide a short overview and it is essential to seek professional advice before applying the contents of this article. No responsibility can be taken for any loss arising from action taken or refrained from on the basis of this publication. Details correct at time of publication.
Smith & Williamson Investment Management LLP is part of the Smith & Williamson group.
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