Value Investors – Avoiding Mining at All Costs, But Why?

This article is authored by MOI Global instructors Will Thomson and Chip Russell, managing partners of Massif Capital, a value-oriented partnership focused on the small- and mid-cap space, with special attention on industrial and commodity-related businesses.

We recently had the pleasure of giving a presentation on our approach to investing in mining firms at a conference hosted by the Manual of Ideas in Zurich, Switzerland. For those not familiar with the Manual of Ideas, it is a community of value investors that is run by the author of a book by the same name, a book we highly recommend to anyone who has not read it.^[1] As far as investor communities go, Manual of Ideas is as good as it gets. John Mihaljevic, the author of the book, has managed to create a diverse community of value investors that we are privileged to be a part of.

Events are a rich mix of successful entrepreneurs turned private investors, fund managers, chief investment officers of foundations and endowments, venture capitalists, etc. We learn a great deal from the conferences and are often convinced that what the group gains from our attendance pale in comparison to what we gain. While there is a great diversity of thought and investment acumen at these events, investing in mining firms is a rarity.

At the start of our presentation, entitled “Beyond Commodity Prices: Finding Value in Mining Firms,” we asked the audience “who invests in mining firms?” In a group of roughly 25 people, about three people raised their hand. This ratio seemed to hold for the broader conference audience as well, about 100 or so individuals. We take no issue with investors choosing to avoid sectors based on a lack of opportunities or not being interested in spending the time to bring a company into their circle of competence (there is after all only so much time in the day), but we found the ratio sufficiently skewed to ask most attendees we spoke with why they choose to avoid mining. Based on our conversations, there are three areas of concern:

1) Mining was too volatile;
2) Mining was too technical, and;
3) Many felt uncomfortable forecasting commodity prices.

Regarding the first issue, volatility, we never really figured out how to respond to this concern. We like volatility; it creates opportunity even if it creates heartburn. Confusing the absence of volatility for the absence of risk is also not appropriate. Furthermore, much of the volatility in the mining sector is driven by commodity price movement. Often the impact of commodity price moves on the value creation of mining firms is illusory, or transitory, with minimal impact (we will show how this can be the case later). As for the technicality of the investment, we find little evidence to suggest mining is any more or less technical then numerous different areas in which people find high-quality investments.

The final issue, forecasting commodity prices, is an interesting concern. Regardless of the asset, an investment is always worth the present value of future discounted cash flows. This means that present value assumptions are always about events in the future and always about forecasts of some kind, which is to say an investment is always made in the presence of uncertainty about how future cash flows will unfold. The key then to the investing process is not the pursuit of a precise forecast, whether that be of commodity prices, demand for some consumer good, the stability of pricing for services, etc. but coming up with a method of gaining conviction about the potential value of a company across a range of potential futures. We do not claim to have the ability to forecast commodity prices, nor are we familiar with anyone who does, but we also don’t see it as a key to successful mining investing, just as predicting the future price of advertising on Facebook or the future price of Tide detergent is the key to investments in the social network or in Proctor and Gamble.

We approach our due diligence of mining investment as follows:

First, we evaluate the management team, project risk, the balance sheet and finally, we assess the present value of the company using probabilistic scenario analysis within the context of the capital cycle of all the firms that mine for the target company’s commodity. The front end of this process (management teams, project risk, balance sheet) is no different than the process one might take for any other company. The back end differs only insofar as we must seek to establish conviction around there being tailwinds for a company’s industry in the form of both industrywide capital allocation and medium to long-term commodity price movements (i.e., higher probability of commodity prices moving up then down, that statement is the extent of our commodity price forecast).

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[1] If you are an investor in Massif Capital and have not yet read this book, please contact us and we will send you a copy.
[2] Our understanding of momentum is shaped by white papers produced by AQR and by the book Quantitative Momentum by Wesley Gray, as such it is limited in diversity of perspectives. We hope that any readers who have seen a discussion of the link between the capital cycle and momentum will reach out so we can investigate this link further.
[3] Those well versed in the thinking of Karl Popper and George Soros will see a direct link to the General Theory of Reflexivity in this understanding of the capital cycle.
[4] By compounding errors, we mean erroneous assumptions or conclusions made on the basis of erroneous assumptions or conclusions, the end resulting being an exponential growth in the overall error of the forecast.
[5] The viciousness of turns in commodity cycles has much to do with the fact that what depresses the returns of producers (new supply) also depresses the price of commodities, creating a double impact on a firm’s financials. In this way the capital cycle takes on additional importance for commodity firms in that where an industry is in the capital cycle is telling of the likely medium to long term direction of the commodity price due the link between price and supply.
[6] High levels of M&A do not always indicate this, as with all things market related the rules are not hard and fast.
[7] Can Gold Industry Return to Golden Age, McKinsey
[8] Ibid.
[9] Ibid.
[10] We utilize Palisades @Risk software for our Monte Carlo Simulations. We integrate it into standard DCF analysis by substituting variables that might traditionally by forecasted on the basis of historical averages with variables that are actively changed across thousands of scenarios that mimic a sequence of random historical pricing events for a given variable. The result is a more multifaceted valuation output.
[11] A three-point valuation is a sampling approach, in the language of stochastic processes, it creates alternative sample paths, meaning we see only one possible outcome among a collection of many possible outcomes. Furthermore, in the case of valuation it is a deterministic outcome because primary variables are decided ahead of time by the analyst. Monte-Carlo creates a random sample path, meaning the output is a succession of virtual events subject to varying levels of uncertainty.
[12] Stochastics is a branch of probability mathematics that concerns itself with the study of the evolution of successive random events, Nassim Talab refers to Stochastics as the mathematics of history.

Disclaimer: Opinions expressed herein by Massif Capital, LLC (Massif Capital) are not an investment recommendation and are not meant to be relied upon in investment decisions. Massif Capital’s opinions expressed herein address only select aspects of potential investment in securities of the companies mentioned and cannot be a substitute for comprehensive investment analysis. Any analysis presented herein is limited in scope, based on an incomplete set of information, and has limitations to its accuracy. Massif Capital recommends that potential and existing investors conduct thorough investment research of their own, including a detailed review of the companies’ regulatory filings, public statements, and competitors. Consulting a qualified investment adviser may be prudent. The information upon which this material is based and was obtained from sources believed to be reliable but has not been independently verified. Therefore, Massif Capital cannot guarantee its accuracy. Any opinions or estimates constitute Massif Capital’s best judgment as of the date of publication and are subject to change without notice. Massif Capital explicitly disclaims any liability that may arise from the use of this material; reliance upon information in this publication is at the sole discretion of the reader. Furthermore, under no circumstances is this publication an offer to sell or a solicitation to buy securities or services discussed herein.