Fund managers Graham Mason and Gary Quinn from Prudential argue that it should not come as a surprise if resources shares continue to be under pressure after the sector returned 60% in the first nine months of the year. To minimise the setbacks, the fund has focused on stronger commodities, such as oil and iron ore, and avoided the weakest, such as steel and gold. It also prefers low-cost producers such as BHP Billiton and Implats.

Financial Mail - 4 November 2005

The portfolio's Resource holdings performed strongly, returning 31.1% against the Resource Index return of 25.5%, once again on the back of renewed commodity strength. The best performer was Kumba with 77.3%, followed by Scharrig Mining with 63.4%. The JSE Resource Index returned 60.0% for the year to date and although valuations are moderate, commodity prices are very high and it should therefore be no great surprise if a setback occurs. The fund's Basic Industries also outperformed the index by 5%, while the Food holdings underperformed the index return for the quarter.

This cycle is clearly not normal. Oil prices at $30 a barrel was supposed to kill the global economy three years ago. With oil at $65 a barrel nobody is sure anymore. The bull market in Copper should have ended 18 months ago given normal price ranges and supply-side response. The bull market has continued and now get media speculation that the copper price is being manipulated. BHP Billiton management perhaps sum it up best, by saying that although prices will eventually fall, nobody is sure when, from what level, or for how long.

Given these times, the portfolio is structured along the following lines: stay with the commodities that appear the strongest (mainly oil and iron ore), and avoid the weakest (mainly steel and gold). For protection, when each individual commodity does turn, to position ourselves in companies with a combination of high margins, diversification and a clear advantage on the cost curve. Hence our preference for example, BHP Billiton over Transhex. BHP Billiton is diversified, is low on the cost curve and has geographic and operational spread. Transhex is only exposed to diamonds, has no real geographic diversification, has declining reserves and is high on the cost curve. As a kicker we pay less for Billiton than for Transhex. Another example would be Impala over Harmony. Impala has exposure to Platinum, Palladium, Rhodium and Nickel. Thus, while Palladium disappointed over the past 12 months, Rhodium has more than compensated. In addition to the South African PGM operations, Impala also derives significant income from its toll refining operations. Its operations are among the lowest cost in the industry. It has a significant stake in Aquarius as well as the large reserves in Zimbabwe. Despite the rand strength, Impala's margins have hardly changed over the past three years. Harmony, for all intents and purposes, is only exposed to South Africa. The bulk of its profits only come from three shafts. If it has any diversification, it is in the number of loss-making shafts. Its cost structure makes it one of the highest cost producers in the gold industry. As in the previous example, we get Impala for half the price of Harmony.

Resource stocks have had a good year so far, and the two main reasons for this are quite different. A large portion of Resource stocks have benefited as a result of forecasted earnings being higher. In this category are the Golds, Amplats and other marginal producers. In a way, investors are prepared to buy the companies in anticipation that earnings are going to bounce strongly. They are correct in their assessment, but there is a price for everything. Added to this is the risk that the forecasted earnings growth will actually disappoint.
The second category of Resource stocks that have done well are those that have performed because actual delivered earnings have grown strongly, for example Billiton and Highveld. In these stocks people feel that earnings will fall dramatically going forward. This is probably the case for Highveld, but perhaps investors are too fearful of owning companies where earnings fall. We don't mind, as long as we have a cheap valuation that protects us from the negative news flow that invariably surrounds falling earnings.

The month recorded strong performance coming from all the sectors with the exception of Gold Mining, which returned -5.3%. Billiton and Sasol, the fund's two largest holdings returned 8.3% and 8.5%, while the resumption of growth in China has also helped the two Steel stocks in the portfolio, Highveld and Mittal, which returned 10.6% and 16.1% respectively.
Two themes are starting to dominate the SA Resource market.
The first is the revised forecast for the rand, which has moved substantially weaker for the next two years. This is largely as a result of the dramatic change in the dollar/euro and people's outlook thereof. Pessimistic targets of $1.40 to the euro have been trimmed to as far back as $1.25, which has resulted in substantial increases for SA domiciled resource counters. Stocks such as Amplats, although still expensive on earnings, are now much more neutrally valued on long-term DCF's. This is mainly due to the long-tail business expansion plans that Amplats enjoys. The portfolio is not currently structured to entertain a structurally weaker rand. However, it will start to take on more rand exposure. While we do not believe the rand will substantially weaken, it no longer makes sense to have a portfolio bargaining on a stronger rand.
The second theme is the realisation that China imports as well as exports. Where China exports (steel, aluminium and textiles), prices will be poor. In the areas where China remains a net importer (oil and copper), the outlook remains very favourable. This explains why the market has taken such a dim view of stocks like Mittal. By contrast, BHP Billiton and Sasol have displayed no such weakness, despite the overall fear that China may slow.

The fund has returned 31.8% (annualised) since we took over the investment management (1 June 2004) versus the Resources & Basic Industries sector mean of 30.9% (annualised).
The commodity and macro environment is certainly sending mixed signals. The valuation of cyclical counters has no such uncertainty - Mittal's PE of 5, Highveld's of 3.5, Billiton's of 10 and Kumba's of 8, have all cast their vote firmly in the camp of a dramatic slowdown. We currently think that this outlook is too pessimistic and that the world economy would need to experience a significant slowdown for these valuations to be realistic.
Certainly, news flow will not be supportive of stock prices, and one can expect choppy price moves going forward.

We are still comfortable in having a large presence in the Diversified Miners, versus the rand sensitive Mining stocks - primarily due to the valuations, but also because we believe that the rand would need to depreciate substantially to make a difference to earnings. Secondly, cost pressures in South Africa do not look as if they will be alleviated.
The choice between Resources and non-Resources is less clear, as the valuations of Construction and Food companies are not cheap. The valuations are more neutral, but being Food and Construction companies, their earnings have a history of being volatile and unpredictable - as we have witnessed in the last month with Aveng and Afgri. In addition, we are a bit concerned about the consensual view that the rand will remain strong for the year.

For the quarter the Resources Index returned -8.2%, with Sasol the best performer with a flat return for the month.
Most of the large Resource counters, with the exception of Gold and Amplats, are trading at reasonable valuations. The concern going forward is where the next round of earnings growth will come from, and what management will do with the excess cash. Billiton has decided to spend $8 billion to buy WMC, an Australian copper-nickel miner. The deal probably has long-term benefits but a very full price was paid. The deal illustrates that there are very few acquisition targets on the horizon. In addition, there are only a limited number of organic projects that the Diversified Miners have at their disposal. This lack of future resources is driving the upward revision to long-term prices. Offsetting this view of rising long-term prices is the theory that this is a classic boom-bust cycle and we are right at the top - at Prudential we are more in the former camp.

The fund had a positive return for the quarter, with the Resource holdings returning 20.4%. Steel returned 11%, but the rest of the Industrials detracted from performance.
The first quarter was very strong for commodity prices. In addition to the base metal performances in copper and aluminium, oil also traded at record highs. Concerns that the high oil prices would derail economic growth have not materialized so far. Iron ore prices were also renegotiated and achieved the highest ever increase of 70%. Twelve months ago there was some skepticism about commodity prices and the commodity shares were valued as if commodity prices would fall sharply. A year later we have much higher commodity prices, but the same skepticism is not apparent.
It is fair to say that the valuations are not excessive in the Resource counters such as Kumba, Billiton and Sasol, but the margin for error is a lot less than 12 months ago. We continue to move away from the Basic Industries and Food sectors.

The fund's positive return in December significantly outperformed the index return of -10.9%. The major contributor to fund performance has been the overweight position in Non-Mining sectors such as Steel (45.6%), Food Producers (17.2%) and Construction (34.1%). Within Mining, the low exposure to Gold in preference for Diversified Mining companies was the right sector call. The Goldfields-Harmony hostile merger diminished value for both stocks during the quarter, as negatives relating to these stocks were highlighted.
The strong quarterly performance generated by Gross Domestic Fixed Investment related stocks will be difficult to repeat. Certainly valuations, while attractive relative to Mining stocks, are not attractive when compared to their own historic norms. A good example would be PPC, which although generating healthy earnings and cash flow, currently trades on a price to book of 6x. The average for the All Share is 2.4x. A large portion of the Mining stocks continues to trade at very high valuations (all the Gold stocks, Amplats and some of the smaller Mining companies such as Meterox and SA Chrome) and some of these valuations imply a substantially weaker rand is just around the corner. We prefer to get our rand hedge exposure via stocks with more neutral to cheap valuations, such as Oceania, Sasol, Billiton and Anglos.
Our strategy over the past quarter has been to be underweight the rand sensitive South African domiciled Mining companies. Not only were the earnings under pressure, but also the valuations were not supportive. With the growing conviction that strong commodity prices, plus the weak dollar equals a strong rand, the scope for earnings disappointments amongst domestic miners is high.
Going forward, we are likely to maintain this stance unless there is some narrowing of valuation between the low margin domestic producers and the high margin diversified miners.

The major contribution to fund performance has been the overweight position of non-Mining and, within Mining, the low exposure to Gold. The Goldfields-Harmony hostile merger has continued to detract valuation from both stocks, as negatives relating to each stock have been highlighted. In the case of Harmony, the extent of the loss-making operations and doubt over the economic viability of Harmony's disclosed reserves have become apparent. In the case of Goldfields the dilutionary impact of the IamGold deal has detracted from their valuation. Our preferred Gold share is AngloGold and we have some small exposure to Goldfields. In our opinion, the Harmony deal is materially worse for Goldfields shareholders than the IamGold transaction.
Our preference for BHP Billiton has continued to bear fruit, with Billiton returning 8.1% versus the Resource Index of 1.6%. With the growing conviction that strong commodity prices plus the weak dollar equals a strong rand, the scope for earnings disappointments amongst South African domiciled miners is high - hence our preference for BHP Billiton, which has the lowest exposure to the rand.