Matt Griffin
Given our investment philosophy is ‘earnings drive share prices’, we typically don’t buy resources stocks until there is a solid framework around resource/reserves and a scoping or feasibility study, with a pathway to production in the next few years. We typically need to have a positive view on the underlying commodity, although are more focused on what we consider to be internal company drivers that can deliver value that is not priced into the shares. This can include a differentiated view on things like the production and cost profile, mine life extensions or growth projects.
Companies that we deem to have higher risk profiles, such as those building or commissioning projects, with elevated debt levels, or with a higher position on the cost curve, have position sizes adjusted to the lower end of the typical portfolio range to account for these potential risks. For us, a good management team is hugely important in the resources space: proven operators who have a track record of being conservative and focus on shareholder returns (rather than risky growth projects or empire building) generally deliver outsized returns for investors, especially given the volatile nature of commodity markets and mining stocks.
Trends to watch
Raising money has become harder for many smaller, younger mining companies, which we expect will flow through to lower exploration and drilling activity in the coming year. Having said this, good projects can almost always attract funding, and there have been a number of exciting new discoveries in the battery materials space.
Building new projects has been exceptionally hard over the past few years as cost inflation and supply chain issues have seen large capex increases and delays. The vast majority of ASX-listed juniors who have commissioned projects in the past year have required a ‘top up’ equity raise to cover cost overruns and working capital. This has typically been done at a significant discount to the main equity raise price for project financing, meaning investors are less incentivised to own companies during the development period.
The market seems to have forgotten the experience of 2016–2018 in lithium, and just how hard it is to commission new lithium mines. We are again starting to see some of these issues resurface in commissioning, with target recovery levels taking a long time to be met. Investors are also discounting the potential for new extraction technologies such as Direct Lithium Extraction (DLE), which was viewed much more positively a few years ago.
We have observed that there has been a big step up in the implementation and communication of environmental, social and governance (ESG) practices and messaging from junior miners over the past year. Most new projects are being designed with a renewable power component (typically solar) included, and native title engagement is becoming increasingly more important given the lengthy permitting processes.
What sustainability means to us
Sustainability means two things to us.
Business models – It is the sustainability of the business model and earnings stream of a company. This relates to qualitative factors that we research, such as industry structure, competitive positioning, the impact of technological change in an industry, and growth options and cost levers the company has available. Looking at management tenure, track record and alignment is also a big component of this.
ESG – We have a dedicated ESG team that engages with companies and assesses their ESG credentials on a range of metrics. We score companies on both business sustainability and ESG, which feeds into our investment process. Apart from general restrictions on tobacco and controversial weapons, we don’t exclude companies from our investable universe just because they have lower sustainability ratings, however this becomes a trade-off against the return expectation. Companies with lower sustainability ratings require a higher expected return to make it into the fund, and vice versa.
With respect to the resources sector we will consider carbon emissions disclosure and a company’s proposed pathway to reducing emissions, in addition to the social side of ESG – workforce measures such as safety and modern slavery, and the impact of operations on local communities. Governance is always the most important factor in small cap stocks, regardless of sector. We don’t need companies to tick all the boxes on governance, especially at an early stage in their lifecycle, but we believe a strong board with appropriate skills and incentive frameworks are critical factors in future success.
The influence of geopolitics on mining
Politics is becoming increasingly important in the mining space. The Russian invasion of Ukraine saw energy security become a critical issue and political tensions between China and the US has seen the introduction of new legislation such as the Inflation Reduction Act, aimed at securing more supply of critical minerals. Some of these policies have been very positive for the battery materials space, with low-cost government funding and grants being handed out for domestic projects. However, the requirement for downstream processing in some jurisdictions is increasing costs and risks, especially in countries with high-cost labour and a lack of technical expertise in these areas.
The re-routing of global trade routes and supply chains will mean a huge amount of capex will need to be spent over the coming decade in western countries. This will increase security of supply but also lead to higher costs and inflation. We believe long-term price assumptions for many commodities will need to be revised upwards over time to account for this.
We are happy to invest in most mining jurisdictions, and our process around the sustainability of business models applies to this too: less favourable jurisdictions require higher returns to attract our investment. We currently have holdings in a handful of companies with mines in various African countries, with good management becoming a critical factor here, as companies need teams who have experience operating in the region and spend a lot of time on the ground over there. Due to a lack of historic exploration compared to countries such as Australia and Canada, junior companies in Africa can discover very good deposits and bring them to production at a relatively low cost. Interestingly, the majority of cashflow generated by ASX listed junior gold miners over the past three years has been generated by African operations, while the older mines in West Australia have seen increasingly higher costs and production declines.
The prognosis
We believe we will see more mergers and acquisitions in the year ahead, particularly in the junior gold space. The large amount of money in various indices means as companies increase in size and gain index inclusion, they typically trade on a premium given the weight of passive buying that follows. This can become a self-fulfilling cycle as scrip-based acquisitions are then more accretive. In our view, the reduction in capital raising activity will see some juniors under pressure to sell and realise a premium for shareholders, rather than slow exploration and go into hibernation mode. Many major and mid-tier miners are struggling for organic growth options and have relatively good balance sheets, and may cast their eye more towards inorganic opportunities.
As is often the case, most acquisitions make sense on a spreadsheet, but few add value in real life. Cultural alignment and the ability to extract synergies from the operations is crucial to creating shareholder value in the medium-term.
Parting thought
When assessing idiosyncratic opportunities within the ASX small resources cohort we look for many of the same attributes as we do with industrial companies, including strong management teams and positive sustainability characteristics. Key to success is having a deep understanding of the risks involved in the company, understanding where a company is in the earnings cycle as well as the fundamentals driving underlying commodity prices.
By Matt Griffin, co-portfolio manager, Australian Small Companies