Screening for value in the resources sector

In my last article, I started to look into the details of the companies highlighted by my 52-week low screen for value. I covered those that fell loosely into the Retail, Media and Investment Company categories. I found four of the companies warranted further investigation as potential investments: Angling Direct (LON:ANG) National World (LON:NWOR) Logistics Development (LON:LDG) Inland Homes (LON:INL)

In this article, I continue to search for value amongst the rest of the 52-week low screen results, looking first at the Resources companies and then anything else that wasn’t easily categorised.

Resources: understanding the capital markets cycle in key

Unlike many value investors, I am not averse to investing in resource companies. Chosen well, such companies often generate very high cash flows, something which is attractive to the value investor. There are two risks with investing in producing resource companies. The first is that those high cash flows end up short-term in nature. The second is that the cash never finds its way back to shareholders and instead ends up building empires for the directors, usually at the top of the cycle.

When investing in resource companies, it pays to consider the capital market cycle to avoid paying up for cash flows that shortly disappear. And so, let's start with a look at how the capital market cycle works.

When prices of commodities are high, this attracts new investment into the sector. When large amounts of money have been invested in developing new production, the future returns are likely to be poor since the extra supply generated will reduce commodity prices. However, new mines or oil fields can take a long time to develop. Depending on the commodity, the time from discovery to production can be between five and ten years. Therefore, those who own an asset that comes on stream quickly, or remains in production after others have been depleted, benefit disproportionately from price rises due to a general lack of new supply in the market. In these cases, those excess profits can be earned for many years. In contrast, companies who are late to the party because they only started developing a resource once prices were high and investors were willing to invest in new resources tend to suffer when all the new production comes on stream together. For this reason, value investors tend to focus on companies that already have production and cash flow.

Capital market cycles can vary in length. Over the last decade, the oil market cycle was particularly rapid due to US shale oil production being the swing producer. Unlike developing large, deep-sea oilfields, shale oil wells can be drilled and completed relatively quickly. All it requires is capital to fund the upfront costs. This meant that although shale oil also had boom and bust cycles, they were shorter in nature and generally kept the oil price low.

However, more recently, the focus on ESG has meant that banks are unwilling to fund large shale oil drilling programs. Production growth has to come from reinvested profits rather than funded through debt. Although this hasn’t removed the cyclical nature of the oil markets, it does mean that the response to current oil price rises is slower than in the recent past. This effect is visible in the global rig count, which is far lower than it has been for the same oil price previously. I expect this will normalise eventually. However, in the meantime, it will generate extra profits for those oil companies with producing assets.

To avoid the other major risk of investing in resource companies: empire-building, shareholders should look for companies with a track record of returning surplus capital to shareholders and management teams that are owners of the equity as well as hired hands.

With these factors in mind, I take a look at the Resources companies the screen has highlighted:

Atalaya Mining (LON:ATYM)

Atalaya Mining is the new name for EMED Mining. They operate a copper mine in Spain. The valuation metrics here look compelling, particularly the price to free cash flow and dividend yield:

However, the copper price has fallen about 25% since the start of June, and brokers have been reflecting this in lower earnings forecasts:

There are long-term reasons to expect copper to do well, such as the trend for increasing electrification of personal transport. And we can also expect some supply constraints; Chile is the biggest global producer of copper, and a new government there has been turning down applications for new mines in the country due to environmental concerns. With a producing mine and around 12 years of mine life, I would expect Atalaya to be able to benefit from these trends. This makes it a good proposition for investors willing to look through any short-term copper price weakness.

Capital (LON:CAPD)

A well-known aphorism suggests that the people who really got rich during the gold rush were the providers of picks and shovels. Capital Limited is the ultimate mining “picks and shovels” company; it provides drilling and mining services, and analyses drill samples for miners, primarily in the gold sector.

The management here have a history of acting countercyclically. During the last downturn for drilling services, the company cut capex, paid down debt and paid dividends. When the gold price picked up, but capital was scarce, they used their balance sheet to support gold explorers and win drilling business. Now the sector is booming, and they have been adding to their fleet of rigs to maximise revenue and profits. Unlike many competitors, they have been locking in long-term contracts at favourable rates, insulating them somewhat from the downside when the cycle does turn. However, there is little sign of a downturn in gold drilling activity happening any time soon:

On top of this, Capital’s 75%-owned labs business, MSALABS, is growing revenue at a phenomenal rate of around 100% per annum. While the drilling & mining services businesses are focused on the more-risky African market, the labs business also operates in more secure locations, such as Canada.

Despite these desirable traits, Capital trades at a material discount to both listed peers and the wider market. The Stockopedia consensus has them on a forecast P/E of around 5. Last year the company repeatedly increased their revenue target range. There is no guarantee they will do it again this year, but they have a history of underpromising and over-delivering. In response to strong trading, their broker Berenberg have increased their price target six times in 2022, which now stands at 168p, some 87% above the current price.

The recent increase in net debt may worry some, but given the strength of their end markets, investing for growth makes sense. The Executive Chairman, a former investment banker with an excellent understanding of capital market cycles, owns 12% of the equity. In addition, the company pays a dividend and has bought back shares recently. These factors suggest that they will not pursue growth at any cost.

Gem Diamonds (LON:GEMD)

Gem Diamonds operates the Letšeng mine in Lesotho. Diamond prices have decreased this year as the war in Ukraine has dampened the demand for luxury goods. However, from a longer-term view, prices remain elevated:

Source: http://www.idexonline.com/diamond_prices_index]

In this context, Gem are highly profitable:

However, there are a number of reasons why these figures may not reflect economic reality going forward:

1. The highest prices per carat are for the rare, large diamonds the mine produces. This means that revenue can be lumpy and unpredictable.

2. Like many African countries, Lesotho is proposing a change to VAT legislation that would prevent input VAT, currently paid on items procured for day-to-day operations, from being reclaimed. The government also has the right to both royalties and a carried interest on top of income tax payments.

3. The company also have a policy of capitalising and then amortising waste stripping at the mine, which means that cash flows are far more variable than profits and metrics such as EBITDA are largely meaningless in this case.

Overall, this means that to get a proper assessment of the economics here, shareholders will have to generate their own model of the company. Something that is not straightforward. I am putting this one in the “too hard” category.

Kenmare Resources (LON:KMR)

Kenmare Resources produces heavy mineral sands, a product that many investors won’t be aware of. Heavy mineral sands contain Titanian Dioxide. They occur in various forms and are founds in many products we use day to day. For example, ilmenite is used in almost all plastics and paints to provide opacity. Rutile is a raw ingredient in producing Titanium metal for aircraft and other engineering applications. Zircon is found in most tiles and ceramics.

Given their ubiquity in everyday materials, demand for heavy mineral sands tends to roughly track global GDP. However, the lack of new capacity development means this sector represents a strong capital market cycle play. As the following chart from the latest Kenmare presentation shows:

This supply-demand imbalance has been driving strong pricing. Combined with the investments that Kenmare have made in increasing production, this has driven record profitability:

A large fall in global GDP remains a risk to demand here, but if it happens, it will also impact the willingness of producers to invest in bringing new production on stream. The forecast P/E of 3 and dividend yield of almost 9% provide a large margin of safety too.

Metal Tiger (LON:MTR)

Metal Tiger is more like an investment company with ASX-listed investments. Two investments they describe as active: Cobre and Southern Gold. Their stake in much larger Sandfire Resources they call a passive investment. Plus, they have a project investment and a royalty investment. However, largely-illiquid, pre-production or hard-to-value investments in the mining sector aren’t the structure value investors usually look for, so I am excluding this from further research.

Pharos Energy (LON:PHAR)

Pharos Energy is the renamed SOCO International that was popular with retail investors many years ago. Although the company retains its core Vietnamese production assets, its exploration efforts in Vietnam have failed to find any significant additional commercial oil so far. In an attempt to grow again, the company acquired production licenses in Egypt and renamed itself Pharos Energy to reflect this new focus. The idea was that the cash flow from Vietnam production would fund the development and expansion of the Eqyptian assets. However, growing production in Egypt has proved to be more difficult than anticipated. This left the company with net debt, and it has now completed a farm out of the Egyptian licenses to another party to fund the investment they have been unable to do.

Despite these challenges, the current oil price means their production should be throwing off cash. However, their reserve-based lending has required them to hedge a proportion of their output at much lower prices. And there has been criticism from some quarters of the level of management remuneration. Given that they now have two non-operated assets, I think there is some validity in this. Still, the brokers’ forecasts are for a forward P/E of 3.5 and with a positive trend:

Given that group revenues for the six months to 30 June were c. $129m prior to a hedging loss of c.$17m, the $194m revenue forecast for the full-year looks likely to be beaten. However, cash flow has been relatively weak, with net debt dropping just $19.4m in the first half, despite receiving a $5m farm out payment in the period. The H1 capex in Egypt was $10m, and with $19m guided to be spent here in H2, plus $24m in Vietnam, the rest of the year is not looking good from a free cash flow point of view, despite the strong oil price and some hedges expiring.

The company has recently announced the start of a share buyback, so management clearly believes the share price to be undervalued. However, at $3m total, it is less than 3% of the market cap, and no dividend has been paid since 2018. The 2023 forecast P/E of just 1.8 means that this company is worthy of further consideration for those who believe that the oil price will remain at current levels for some time. However, given the poor management track record, you’d want them to be giving some further commitment to shareholder returns. Acting pro-cyclically and poorly executed empire-building attempts remain real risks here.

Sylvania Platinum (LON:SLP)

Sylvania Platinum has the right to process the tailings from the Samancor chrome mines in South Africa together with historical tailings piles. They extract Platinum Group Metals, which generate their sales, and chrome, which they return to Samancor for a nominal fee. Since the metals they produce, such as Platinum, Palladium and Rhodium, have jumped in price in recent years, this has made the company highly profitable. Broker forecasts are for this strength to continue but for EPS to decline slightly versus an exceptional 2021:

Although the ability of the company to produce at current rates will be limited by the amount of historical tailings dumps they have access to, the presence of fresh tailings arriving from Sunamcor means that Sylvania can continue at a reasonable level of production, as long as Sunamcor are still producing chrome.

The level of earnings has enabled an impressive cash build, even as increased working capital has been required to support higher trading levels:

As always with large-cash-balance companies, the big question is, what does the management intend to do with this? So far, they have been reluctant to return significant amounts of it to shareholders. They do pay a dividend and occasionally operate a share buyback, but the cash continues to build. This may be to do with challenges getting large amounts of cash out of South Africa without incurring withholding taxes but may also indicate that the management are considering becoming a chrome/PGM miner directly, rather than simply being a tailings reprocessor. The management can be a little evasive about this and other topics at times, which doesn’t always build confidence. Such a change of strategy could impact the risk-reward significantly.

The other factor to consider is that much of the current profitability is due to high Rhodium prices. The primary use of Rhodium is in automotive catalysts. The price of Rhodium has held up remarkably well given the well-publicised production constraints the automotive sector has faced. This suggests that the market is currently well-balanced, and any growth in automotive production could see price rises, not falls. However, long term, increasing electrification of personal transport may see demand, and prices, fall. The current price looks to be a compelling valuation as long as investors are comfortable with the political risk, the Rhodium market outlook and the management’s capital allocation skills.

Serabi Gold (LON:SRB)

Serabi Gold have operated producing mines in Brazil for many years. Unfortunately, despite their longevity, they have yet to pay a dividend, and the share count has been increasing:

Although some of the weakness will be due to the wilting gold price, the broker consensus doesn’t fill me with confidence:

In light of this, the forward P/E of around 9 makes me think there is better value in the sector elsewhere.

Trinity Exploration and Production (LON:TRIN)

Trinity Exploration and Production is an onshore oil producer in Trinidad and Tobago. Looking at their 2021 results presentation, it is good to see that they start with a commitment to both profitable growth and shareholder returns. However, they have yet to actually pay out on those intentions. Lower EPS forecast for this year on higher revenues suggests they may be facing cost challenges:

Although part of that weakness will be their policy of hedging around 50% of their production.

A six-well drilling campaign that started at the end of June has the ability to increase production materially:

Combined with the re-pricing of their hedges, this means that the 2023 estimates put them on a forward P/E of 3. This looks too cheap, particularly given that they have possible exploration targets in their portfolio as well. The mix of low-risk onshore production and exploration upside seems particularly attractive.

Wentworth Resources (LON:WEN)

Wentworth Resources has an interest in the Mnazi Bay gas field in Tanzania. Their gas has to be sold into the local grid for power generation. Still, this is profitable enough for them to pay a dividend that is approaching a 10% yield and have half their market cap in cash. Of course, what also matters is how long production can be maintained. At current production rates, the estimate for economically recoverable gas extends to 14 years. This is long enough to consider this on more long-term metrics such as price-earnings ratios rather than having to do a short-term discounted cash flow analysis.

They recently hired a COO which is a sign that they want to do something with that cash. But unfortunately, the deal they signed this year appears to have fallen through as other partners have exercised their pre-emption rights. So although there may yet be a deal to be done, this remains a non-operated single asset producer in a risky jurisdiction which may make it a step too far for some. However, the valuation looks compelling for investors willing to take that risk.

And the rest

The final three companies were not easily categorised, so I’ve left them to last:

NAHL (LON:NAH)

NAHL used to be called National Accident Helpline. It provides legal services, mainly on a no-win no-fee basis. This appears on our list to look at due to the following collection of green metrics:

However, as a largely people-business, this should be cheap. With many listed people businesses, the returns accrue to employees, not shareholders, in the long run. The lack of forecasts in the market, no dividend, and significant debt compared to market cap means that these metrics are essentially meaningless for making an investment decision here. Given the nature of the business, I am not inclined to look into it any further.

Ocean Wilsons Holdings (LON:OCN)

Ocean Wilsons Holdings is a Brazilian shipping company that also holds a variety of equity investments. This means their fortunes are tied to both the Brazilian and global economies. The hybrid of operating and investment company makes them hard to value. The 0.68 price to tangible book value is attractive as an investment company but means the company has a low return on capital when considered as an operating company. The earnings tend to be volatile, and the share price largely follows the earnings outlook and ignores the investment side of the business.

The price-earnings ratio is undemanding at around eight on a forward basis, as is the 6%+ yield, although earnings are forecast to be down on 2021 levels. Given all the moving parts, I am also putting this one in the “too hard” category. It could make sense to hold Ocean Wilsons in a highly-diversified value portfolio based on quantitive metrics only. However, in a highly uncertain economic world, I don’t think I will be able to gain any specific insight into trading that more sophisticated investors don’t already know.

Tyman (LON:TYMN)

The Stockopedia summary says, “Tyman plc is a supplier of engineered fenestration and access solutions to the construction industry.” This means they make products such as locks, hinges and seals for doors and windows, plus home security products. The company is trading well, and the general Covid-19 market weakness is not visible on the long-term EPS chart, which suggests it is well run:

The apparently cheap rating of an 8x price-earnings ratio depends on them hitting 2022 forecasts. Their AGM trading statement in May seemed confident about doing so. This was reiterated in their H1 results released this week. However, these also showed adjusted EPS up just 3% for the half year. This leaves a lot to do in H2 in a market where their material costs are soaring:

Building materials is a competitive sector, and a mid-30s gross margin and sub-10% ROCE suggests that Tyman’s competitive advantage is not particularly strong. With companies like these, I like to compare them to similar companies in their sector using the Stockopedia comparison tool. In this case, the company doesn’t appear to represent stand-out value compared to other building products companies:

It may be worth considering Tyman as part of a play on the wider building products sector. However, there is little reason for Tyman to be an investor’s sole choice in this space. Given this sector’s inflationary headwinds, it may be worth waiting for greater clarity on the ability to pass on those cost increases without demand plummeting.

That brings me to the end of the first-pass look into the value investment ideas highlighted by the 52-week-low screen. It has highlighted at least 11 companies (including four from my previous article) that I believe warrant further investigation. Of these, four companies I had not considered as investments before, showing what a valuable exercise this has been.

Holding only 11 companies does not make a sensible value portfolio, however. So in my next article, I will look to generate further value investment ideas with a screen that uses a factor that has been around for as long as value investing itself: low price-to-book.

[Disclosure: Mark owns shares in Capital (LON:CAPD) ]