SIF Folio: Can high yielder South32 keep mining big profits?

From time to time, my rules-based SIF system offers me choices that go directly against my own judgements. Most often, this happens in highly cyclical sectors.

The SIF stock-buying screen does not make any attempt to time market cycles or even really recognise their existence. Instead, I simply look for evidence of modest valuation and ongoing growth.

On balance, I think this has probably been helpful in terms of generating positive returns since the portfolio’s inception. Making cyclical calls accurately is notoriously difficult. And as hedge fund legend Seth Klarman of Baupost Group once said, “being very early and being wrong look exactly the same 99% of the time”.

I’m certainly guilty of being very early on some of my sector calls. I’ve been convinced that the big miners must be near the top of the cycle for at least two years now. So far, I’ve been expensively wrong.

Of course, I’ll be right eventually. But Klarman’s words seem pretty apt here.

It’s against this backdrop that I find Anglo-Australian miner South32 at the top of my screening results this week. To emphasise the point, S32 also has a near-perfect StockRank:

I don’t currently have a miner in the SIF folio after my unscheduled ejection of Kazakhstan-focused Central Asia Metals. Should I ignore my views on the mining cycle and add South32 this week, or is now not the right time?

In the remainder of this piece I’m going to take a closer look at South32’s key metrics and the story behind the company.

South32 (LON:S32)

South32 was spun out of BHP (then called BHP Billiton) in 2015. In somewhat simplified terms, it contained the Billiton assets acquired by BHP when those two companies merged. These included coal, silver, lead, alumina, manganese and aluminium. Today we can add nickel and copper to this list.

All of South32’s assets are located in the southern hemisphere, primarily in Australia and South Africa.

The new company got off to a difficult start when commodity markets crashed in 2016. But the rapid recovery fuelled record profits in 2017. CEO Graham Kerr used the momentum (and cash) from that period to start reshaping South32’s portfolio.

Changes made so far include the sales of the group’s South African thermal coal business and the recent $1.4bn acquisition of a 45% interest in the Sierra Gorda copper mine in Chile. South32 is also increasing its production of green aluminium and working on plans to develop a new, low-cost zinc-lead-silver deposit “using low carbon design principles”.

Like many of the big diversified miners, South32 is reshaping its portfolio to target the commodities that will be needed for the electrification and decarbonisation of the global economy.

The bull argument here is that structural demand growth will dampen down cyclical fluctuations. Personally, I think that’s just another way of saying the most dangerous words in investing – “it’s different this time”. But time will tell.

In any case, surging commodity prices mean that profits and margins are extremely high at South32 right now. The group’s operating margin reached 44% during the six months to 31 December.

I think it’s worth bearing in mind the commodity market adage that “the best cure for high prices is high prices”. But if exports from Ukraine and Russia are restricted for the foreseeable future, then it may be that western producers see additional demand for a prolonged period.

South32’s last market update came just before Russia invaded Ukraine. At that time the company reported a fairly positive outlook, although with some caution over regional Covid disruption and rising costs.

Is now a good time for me to add this stock to the SIF folio? Let’s take a closer look at South32’s quality, value and momentum scores.

Value: peak prices?

ValueRank: 67

Commodity producers often look cheapest when they are actually at their most expensive. When commodity prices are high, profits soar and miners tend to trade on low earnings multiples. When prices are low, the opposite applies.

South32 currently trades on a modest P/E of 11 times trailing 12-month earnings. However, the shares also trade at 1.7x book value. My sums indicate that this is the highest price/book multiple since the stock was listed in 2015.

A miner’s net asset value is generally far less volatile than its earnings. For this reason I think price/book can be a useful measure for judging the cyclical value of miners.

Turning to some other measures, South32 scores relatively well thanks to its strong cash generation and recent bumper profits.

• TTM price/free cash flow: 11.1 (100% earnings conversion to FCF)
• Earnings yield (EBIT/EV): 13.0%
• Half-year net cash of $975m suggests the balance sheet is well positioned to handle future problems.

My view: South32’s value metrics do not flag up any major concerns for me. But I do feel they support my view that commodity prices may be approaching a cyclical peak. However, that doesn’t mean prices can’t stay high for a while yet. If that happens, I think South32 might continue to provide attractive returns.

Quality: high margins

QualityRank: 84

South32’s strong QualityRank score reflects both its current high margins and the improved nature of the group’s performance over the last 12 months.

These factors plus strong cash generation combine to give a high F-Score of 7/9 (which could easily be 8/9 in my view):

Profitability: Margins are high at the moment, but they can fluctuate wildly when commodity prices move.

Free cash flow: I’ve already mentioned cash generation, but I thought it was worth a quick screenshot showing how earnings, free cash flow conversion and dividends stack up. It seems clear to me that South32 has a disciplined approach to dividends and pays only what’s affordable each year.

My view: Despite its cyclical profitability, I don’t have any concerns about South32’s quality or its financial safety.

Momentum: the reason to buy?

MomentumRank: 99

A score of 99 suggests South32 shares are benefiting from strong momentum right now. Given the initial nine-month holding period I target with SIF, positive momentum is crucial for me.

Looking at this factor score in more detail, it all looks good to me – with one possible exception.

Price momentum: The stock’s strong performance over the last two years has resulted in a very strong technical setup. South32 is trading close to record highs, with strong volumes in recent weeks.

We can visualise of these characteristics more easily using the volume and moving average indicators on Stocko’s updated charts (you can read more about these excellent new features here):

Earnings estimate: In my view the momentum picture becomes more nuanced when we look at broker forecasts. The trend has certainly been upwards over the last year:

These forecasts leave South32 trading on around seven times forecast earnings, with an expected dividend yield of 7%. These are obviously attractive metrics, all else being equal.

The main weakness here in my view is that analysts do not expect profits to rise any further in FY23 (South32’s financial year ends in June). Indeed, looking at broker forecasts for the company I can see elsewhere, the consensus seems to be that profits will fall over the next couple of years.

Of course, the problem with such forecasts is that they’re little more than guesswork. Using Stockopedia’s own Wayback Machine, we can see how forecasts for FY22 have changed over the last 12 months.

On 24 March 2021, brokers expected South32 to report $645m for FY22:

Today they expect a figure of $2.3bn:

I’ve said it before, but mining profit forecasts are really not very reliable, in my view.

My view: South32 clearly has strong momentum today. But that picture may well change as the year unfolds.

My decision

I don’t see much wrong with South32’s business. The company seems well managed to me and the group’s assets are of reasonable quality, if not always best in class.The risk I can see is the obvious one; future profits are largely dependent on commodity market conditions.

The way I view mining stocks is generally that if I buy a miner during a commodity crash, the risk/reward is weighted to the upside. History suggests prices will recover at some point.

In contrast, if I buy a miner when times are good, I’m betting that prices will stay high. That goes against the grain for me, but I recognise that it still may be a valid approach.

This week, I’ve decided that I should follow the SIF rules. For this reason, I will be adding South32 to SIF and to my personal holdings after this article has been published.

I make this decision with some misgivings, but that’s sometimes the nature of systematic investing.

As always, please let me know what you think about South32 and the outlook for miners in the comments below.