Is it time to buy into mining stocks?

Buying into unloved sectors at the right time can be a highly profitable strategy. One sector that stands out as being out of favour presently is mining. The FTSE World Index – Mining is down over 18% since the start of the year. So is it best avoided or time to buy in?

Expectations for the mining sector rest on ‘super cycle’ theory, which states we are in a period of robust global growth driven by increasing trade in emerging markets, urbanisation and technological innovation. As a result, demand for raw materials is anticipated to continue growing, benefiting firms that produce them. History affords some precedents. The world has experienced two previous economic super cycles: the second half of the 19th century when innovations such as gas lighting and mechanisation transformed everyday life and the mid-20th century, a period of industrialisation and urbanisation between 1945 and 1973, when the world economy grew at an annual average rate of 5%, spurred by post-war reconstruction and the wide adoption of new technologies.

Proponents of the super cycle theory believe a third and even more powerful multi-decade cycle is underway. Developments in IT and telecommunications are linking economies together in an unprecedented way and emerging nations have unlocked their growth potential. Prudent economic policies have enabled their populations to increasingly engage with the world. Increasing wealth and urbanisation amongst these people has caused a surge in demand for commodities. China has been particularly instrumental to this transformation. Between 2000 and 2010 China’s spending on imports of iron ore increased by 42 times, thermal coal 248 times and copper 16 times.

The first decade of this century was therefore a boom time for virtually all commodity producers and mining firms enjoyed record profits. Yet given slowing growth in China and stagnation in much of the West, investors must now consider whether the super cycle is over or it is merely experiencing a blip. Either way, the profitability of the mining sector is in the spotlight, exacerbated by concerns that firms have used profits unwisely. Many are accused of developing too many additional mines, lacking cost control or being over-optimistic regarding commodity prices. It has all added up to negative sentiment weighing on the sector.

However, there could be better news ahead. Following a slowdown in growth in China there are signs the situation is stabilising. Chinese industrial production data has improved since the end of last year, and construction activity is poised to accelerate with transport and utility projects being brought forward. Looking further ahead other nations should also have a more meaningful impact on commodity demand, notably India, Indonesia, Vietnam and the Philippines, which are all still urbanising quickly. The supply of certain vital commodities is already constrained, so increasing demand could translate to higher prices – and profits for commodity producers.

At a corporate level too there is progress. Having been chastised by investors for misallocating capital, company management are taking a more disciplined approach. By instigating and increasing dividends they are able to demonstrate this, so despite the sensitivity of the sector to the health of the global economy I expect a focus on prudent management and yield to become more prominent.

However it is likely to take time to convince investors and for the prevailing negative sentiment to change, but despite this, valuations are starting to look more appealing and commodity exposure may be helpful if inflation really starts to take hold. I have looked at dripping some money into the area in the form of BlackRock World Mining Trust managed by Evy Hambro. The largest holdings are Rio Tinto and BHP Billiton, and this investment trust currently trades at a discount to assets of 10%. Interestingly, the yield is relatively attractive at around 4%, though there is a modest level of gearing, which increases risk. I believe this Trust is worth considering and it remains part of our Foundation Fundlist of favourite funds across the major sectors.

Rob Morgan is the Pension and Investment Analyst at Charles Stanley Direct

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