For the third quarter, the Nedgroup Investments Mining and Resource Fund outperformed the sector mean.
Most of the weakness has been concentrated in platinum and mid-cap mining shares.

A lot can change in three months, and it is important to recognise that the changes in the global economic conditions have deteriorated sharply. It is easy in the price volatility and large price declines to suggest speculation is at work. There is probably some speculation, but the heart of the problem is that global economic growth will be a lot weaker and hence, the demand for metals will be a lot weaker. In this environment, no commodity will benefit and problems that effect steel will also impact oil. However, some mining companies are in a stronger position than others. The losers are those companies whose projects have not been completed; those that rely on future funding, the companies at the wrong end of the cost curve, and those that are single mine operations. Typically, these are the junior mining companies and essentially, their existence has to be called into question. The fund has less than 3% exposure to this group.

The winners are those whose projects are complete, are at the low end of the cost curve, have little debt and are diversified. BHP, Impala and Sasol are good examples.

The fund has sold its entire holding in Mittal as this company is very geared to global growth prospects. The current valuation on most large mining companies does look very attractive. As examples, Anglo American is trading on its lowest trailing PE in 20 years (6.5), Biliton (8.0) on its lowest since the merger in 1997.

Resource stocks in SA had a very strong quarter, returning 12.1%. Given the poor performance of global equities, this was a standout return. Relative to our local financial and industrial sectors, this outperformance was in the order of 22%, one of the largest relative quarterly performances on record.

The above is the idea of economic decoupling being reflected in the markets with lots of faith still placed in China and almost no hope given to the Western world. Economic reality is normally not that extreme, but that seems to be what price action suggests.

The good news for holders of resource companies is that 2008 will deliver record profits for the bulk of JSE resource companies with the exception of paper and the gold sector. 2009 is a lot more difficult to predict and a slowing in earnings growth, if any, is the likely scenario given the growing cost base. The difficulty is knowing what multiple to pay for these earnings given the very high base. While there are many reasons to believe in a long-term structural case for commodities, there are a growing number of headwinds. These are a slowing Asia, the lifting of price caps (or lifting of subsidies) in emerging economies and most importantly, the return of inflation to many parts of the globe.

We still believe that the large diversified companies have the appropriate balance of valuation and earnings certainty to negotiate the next 12 months.

The first quarter of 2008 saw perhaps the biggest dislocation between commodities and the developed world. With a string of negative macro data concerning the OECD, with the US in particular, commodity prices staged one of the strongest rallies from an already elevated level. Hot rolled steel coil, typically the most cyclical of commodities, has risen 40% this year, even in the US where a recession is being forecasted. Elsewhere, iron ore and coal are up more than 70% and precious metals such as gold and platinum have risen by 12% and 32% respectively. This should confirm a growing belief in the decoupling of the OECD and emerging markets such as China and Brazil.

If this is indeed what is happening, then resource companies should be attractive investments. If, however, the latest spurt in commodities is due to a combination of falling supply, at the same time as speculators' need for an asset class outside of the traditional financial instruments, then this current strength in commodities could be false. Everywhere one looks, shortages of skills and key components are leading to supply arriving later than forecasted. In the case of copper, supply has undershot forecasts by 900 000 tons which is some 4% of total demand. In South Africa we are well aware of the lack of supply of gold and platinum despite record prices. Increasingly, it seems as if the world is experiencing a supply shock, which is causing the high metal prices.

It seems too early to conclude the world has decoupled given that it is only six months into liquidity crisis. It would be foolish to conclude that commodities are a safe haven in the financial world, and we have positioned the fund accordingly. In essence we still prefer large cap, high margin companies to low quality resource shares.

The global economy worsened in the month of December and investors in the mining space are still undecided as to how a recession in the US could affect China. This is one of the main reasons behind the wide range of metal forecasts and company earnings. Given the poor macro data, mining stocks were particularly weak in December with Basic Materials declining by 6.37%. Mining Diversifieds returned 28.4% for the year to December 2007. The last four years have been good for this sector but we anticipate 2008 to be a challenging year for mining stocks. Most commodity forecasts start the year being higher than current spot prices. This puts some risk to the earnings outlook. Most mining companies have weak earnings outlooks for 2008 and 2009 and the deteriorating macro outlook has made this worse.

The exceptions to the above are gold and oil. In fact gold and oil trade significantly above current and long term forecasts. The fund has raised its weighting in gold in the month of December. The performance of the SA gold sector has been particularly disappointing with costs and safety issues outweighing the rise in the randgold price. In addition, the sector was very expensive at the start of 2007 and most analysts failed to recognize the deterioration in grade that was taking place in SA. Costs and grade will remain issues for 2008, but at least there is some recognition of these risks. Other stocks that have the potential for significant earnings growth are African Rainbow and Mondi.