Prudential Portfolio Managers

The second quarter has been volatile for South African resources; the JSE Resources Top 10 was down 9% in April, up 12% in May and down 14% in June. Given the weak global back-drop it is not surprising that the stimulus to the JSE resources sector in May from the weaker rand did not hold in June. What initially appeared to be South African specific factors driving the Rand weaker in the early part of the second quarter was overtaken by global factors, with other commodity currencies, like the Brazilian Real and Australian Dollar, catching up on the weak side.

Furthermore, from a global perspective, what appeared to be diminishing risk appetite driven by suggestions of withdrawal of US monetary stimulus, has been overtaken by concerns of slowing growth and tightening of liquidity in China. While China remains the dominant driver of commodity intensive demand, and more generally it is apparent that commodity demand and global emerging market growth go hand-in-hand, a stronger US dollar outlook does not help commodity pricing either.
In this environment, we re-iterate our defensive stance - rather than looking for cheap turnaround opportunities, our focus is to avoid mistakes. Hence we favour low operating and financial risk - high margin and low or declining debt.

Within a South African resource perspective the choices are limited, especially within the gold and platinum sectors - while some traditional measures of long-term value appear enticing, the short-term metrics, specifically with regard to cash flow, are a concern, with the rand, even at current weaker levels, not providing respite.

We also find limited differentiators to identify winners within the precious metals sectors, as the companies have similar headwinds, and the industry cost curves have flattened. In a loose demand environment, as we are currently encountering, a steep cost curve is preferable, as it tends to enforce supply discipline, with high cost production being forced to close, to the benefit of low cost producers. Disincentives to embark on closures in the platinum sector are also based on non-economic factors; while in the global gold sector capex discipline and impairments are only just getting started.

Thus, in a weak sector, the mining stocks that we don't own have been more beneficial than those that we do - our underweight positions in gold and platinum have been beneficial relative to the benchmark - and non-mining resources (Sasol, Mondi, Omnia) and off-benchmark (Raubex, Trencor) positions have helped relative performance as well.

The Fund generated a return of 5.5% for the quarter ending 31 December 2012, compared to the benchmark of 3.9% (Domestic Equity Resources & Basic Industries Unit Trust Mean).
The best performing stocks were Impala Platinum, BHP Billiton and Mondi. The biggest detractors of performance were gold stocks AngloGold, Gold Fields and New Gold. In the latter part of 2012, the South African mining sector has been buffeted by domestic and global factors. Domestic issues were dominated by the aftermath of the August 2012 Marikana tragedy, particularly in terms of the re-setting of industrial relations that is still underway. From a global commodity perspective, the ebb and flow of conviction towards the Chinese commodity demand outlook has fed through to local resource stocks (best illustrated by the fall in the iron ore price - 42% from April 2012 to September and subsequent recovery to above the April high).

Generally, the investment case for the SA resource sector is dominated by the debate on the maturity of the commodity cycle - whether or not the China debate signals the end of the decade long super-cycle in commodities. But as is customary at this point of cyclical inflection, M&A activity comes into play broadly around the ''buy-or-build'' debate, as well as some asset rationalisation (increasing bias towards a ''shrink-to-grow'' strategy, rather than the prior focus on ''growing down the cost curve''). The era of the ''mega-mining'' project may well be drawing to a close (long-lead-time and very high capex projects that are evidence of a company’s confidence in the extended strong demand for the commodity and the stability of the regulatory regime in which they need to invest). The speed of the revolving door of mining CEOs further highlights the point of inflection that we are at.

Gold Fields’ decision to unbundle its declining South African assets from its international and growth mines talks to these domestic and global issues, as does Anglo American Platinum’s ongoing platinum sector review. Anglo American also announced the disposal of its stake in the Palabora Mining Company; and BHP-Billiton, among other global miners, has rationalised capital expenditure plans.

Given the unforecastable nature of these permutations, we focus on bottom-up company specific analysis. On the basis that the primary product of our investment decision process is to identify superior earnings growth (absolute and relative), at a reasonable price, and within this context of inflection and heightened volatility, albeit within a generally resource constrained global environment, we look to maintain a balance of defensive exposure to higher quality earnings (cost competiveness and visible cash flow). Furthermore, PE type valuation techniques are not a reliable stock picking tool in the mining sector currently, as earnings visibility is low.

Our core holdings are in companies with a track record for operating delivery and proven ability to invest through the cycle to give us confidence of their ability to optimise and adjust to this dynamic environment - BHP Billiton, Impala and Mondi fit this profile. We then seek to identify companies that are organically creating earnings outperformance opportunities (independently of the commodity cycle, and while mitigating capex and project risk), as we see in Lonmin, Pan African Resources and Sappi.

The Nedgroup Investments Mining & Resource Fund lost 1.3% over the quarter ending 31 March 2013, while the peer group lost 2.4% over the same period.

The best performing stocks were Sasol, Mondi Plc and Mondi Ltd. The biggest detractors of performance were BHP Billiton, Impala Platinum, Anglo Platinum and AngloGold.

As a broad sector, the global mining industry is facing two multi-year inflections. The first being the slowing of the rate of growth of demand, principally from China; and the second, the maturing of the investment capex cycle spawned by the growth in commodity prices. Iron ore, as the primary earnings driver within general mining stocks currently, reflects this position more than any other commodity. Notwithstanding the loosening of supply and demand balances, individual investment opportunities exist for companies well positioned within their own commodity and capex cycle. Furthermore, valuations across the sector are starting to screen attractively on a normalised margin basis.

During Q1 2013, the iron ore price lost some ground from its Q4 2012 rally and the share prices of the JSE iron ore miners gave up all of their Q4 gains (Kumba and Assore by 13% and 24% respectively). We therefore continue to avoid exposure to iron ore despite good cash generation by the operations and apparently reasonable earnings-based valuations for the shares at current prices, due to our concern of global supply growth in a slowing demand growth environment. At the top of the cycle, we do not view PE type valuations as fairly reflecting the value opportunity in a cyclical mining investment.

Our focus remains on stocks that exhibit some of the following properties: low cost, diversified asset bases, track record for operating delivery, maturing capex projects reflecting in volume growth and declining financial gearing. While value is vital in our investment decision making, we view quality as important, particularly in times of elevated uncertainty. Within our investment opportunity set, we continue to identify BHP Billiton and Mondi as stocks that exhibit a balance of these characteristics, and view Sasol as offering relatively defensive earnings and dividend. While defensiveness is core to our current investment positioning, we to remain open to opportunities that arise within the smaller commodity or company specific cycles, cognisant that the world is resource scarce in the longer term and South Africa is resource rich.