Copy
Gresham House, Ireland   |   View in Browser 
Monthly Monitor | August 2022

Commodities - is cyclical weakness masking a structural opportunity?
 
Commodities were the hot topic at the start of this year as investors viewed them as a hedge against inflation.   

As the year has progressed, the market has started to price in an economic slowdown and the prices of commodities and the companies that produce them have come down in line with this. We believe this cyclical weakness is masking a structural opportunity and the conditions are in place for commodity stocks to shine over the long term.

Well-placed in the capital cycle 

The capital cycle is a simple concept. Low levels of supply in a sector leads to strong pricing for incumbent companies. The high margins lead to over-investment and new competitors entering the sector.

Margins and profitability are soon compressed as excess supply overwhelms demand. With profitability reduced, consolidation occurs, and investment is reduced. This under-investment ensures the seeds for the next recovery are planted. 

Today, we are just coming out of a long period of under-investment in the mining space illustrated by the chart below.

This is the best possible background and despite commodity prices being elevated versus pre-Covid levels, we are seeing very little additional supply being added.

We are in the sweet spot of the capital cycle.  
European mining sector CapEx/Depreciation
Source: Bloomberg, August 2022
The current supply ‘sweet spot’ is likely to be sustained for a longer period than normal for several reasons. 

Firstly, the previous cycle has left investors scarred. The current attractive price environment is not enough to make investors push for expansions. Value destructive investments with capital overruns and delayed deliveries in the late 2000s/early 2010s have led to investors imposing strict capital discipline on management teams.

Secondly, investors have started to view the miners as dividend paying stocks, particularly UK pensions funds. Therefore, investors are imposing capital discipline on management teams. 

Thirdly, increased ESG requirements are being imposed on companies by investors. This means projects require more planning and extended lead times. 

Finally, there is a shortage of large projects in lower risk jurisdictions with amenable governments.

Structural demand growth

Demand tailwinds alone are not enough to sustain commodity bull markets. However, structurally growing demand combined with the supply ‘sweet spot’ is likely to be a powerful force. 

The demand outlook has become increasingly rosy over the last number of years. 

Historically, such high demand increases in commodities have been fuelled by a new major economy or region beginning to industrialise. However, this time it is not a country driving demand, it is predominantly the energy transition (grid network upgrades, solar power, wind power and electric vehicles). 

If we are to come close to the targets set by governments, the demand for minerals will take off over the next few years and be sustained into the second half of the century. 
Total mineral demand for clean energy technologies by scenario
Source: International Energy Agency (IEA), March 2022
Conservative estimates put the demand for renewables, Grid and xEV’s (CAGR) of copper, nickel, and aluminium from 2022 to 2023 at 15%, 22% and 14.5% respectively. 

Urbanisation is a further demand driver - essential infrastructure and electrical wiring are needed as populations migrate towards cities. 

Strong financial position, allowing cyclical storms to be weathered

Mining companies have significant levels of operating leverage. Combining operating leverage with financial leverage has historically proven disastrous for cyclical companies. 

The mining sector has cleaned up its balance sheet over the last decade. The financial position is very strong and even a sustained cyclical downturn would be unlikely to affect the financial position of the major commodity producers.   
Sector net debt to EBITDA
Source: Bloomberg, August 2022

Low valuations on an absolute and relative basis 

Commodities are very cheap versus broad equity markets.

The previous commodity boom from 2000 to 2008 saw the ratio of commodity prices to the broad index treble.  
Commodities to S&P 500 ratio
Source: Bloomberg, August 2022
The absolute valuation levels are also significantly below historical averages. 

Earnings may be elevated but even normalising earnings down to historic margin levels gives us very attractive valuation opportunities. 
European mining EV/EBITDA
Source: Bloomberg, August 2022
European energy EV/EBITDA
Source: Bloomberg, August 2022

Investment opportunity

We believe that the stocks we hold in the commodity spaces will emerge from a cyclical downturn in a better position than their peers. We think that they will be the ones that can take advantage of the huge structural opportunities that the constrained supply/strong demand environment will bring.
 
Their strong balance sheets mean that they can deal with a sustained negative pricing environment if it occurs. Their high dividend yields provide investors with generous levels of income, so we are essentially paid to wait through any weakness.  
Source: Bloomberg, August 2022

Please visit our website for further information. The latest views and insights from the team can be found here.
Investment team

Niall Dineen
Chief Investment Officer      

John Mattimoe
Senior Fund Manager           

Derek Heffernan
Senior Fund Manager       

Pat Kilduff
Senior Fund Manager      
Get in touch with our Client Relationship team
Patrick Lawless
Managing Director
E: p.lawless@greshamhouse.ie
D: +00 353 662 4050
Kathryn Hannon
Head of Private Clients
E: k.hannon@greshamhouse.ie 
M: +00 353 87741 6057
Ian Naughton
Senior Relationship Manager
E: i.naughton@greshamhouse.ie
D: +00 353 662 3986
Sean Breheny
Business Development Executive
E: s.breheny@greshamhouse.ie
D: +00 353 969 3277


Any views and opinions are those of the Fund Managers, and coverage of any assets held must be taken in context of the constitution of the fund and in no way reflect an investment recommendation.

Capital at risk. If you invest in any Gresham House funds, you may lose some or all of the money you invest. The value of your investment may go down as well as up. This investment may be affected by changes in currency exchange rates. Past performance is not necessarily a guide to future performance.


The above disclaimer and limitations of liability are applicable to the fullest extent permitted by law, whether in Contract, Statute, Tort (including without limitation, negligence) or otherwise.

Gresham House Asset Management Ireland Ltd is regulated by the Central Bank of Ireland.  


You have received this email because you are subscribed to marketing information from Gresham House. 
 
IMPORTANT INFORMATION

Gresham House Asset Management Ireland Ltd is incorporated in Ireland as a private company with limited liability (registration number 364773). Its registered office and sole place of business is 42 Fitzwilliam Place, Dublin 2, Ireland. The Company is authorised by the Central Bank of Ireland as an alternative investment fund manager pursuant to the AIFM Regulations. The Company currently provides investment management services to the Appian Unit Trust and the Appian Investments ICAV.

Unsubscribe from this list