Book Reviews

Investing in Mining Companies: Interview with Stuart Baker

There is an excellent interview with Stuart Baker on mining companies in “The Super Analysts: Conversations with the World’s Leading Stock Market Investors and Analysts” by Andrew Leeming.

Stuart Baker spent his first 8.5 years working on oil platforms with Schlumberger, followed by an MBA. After which Stuart started with stockbroker EL&C Baillieu, then went on to head the mining team at BT Alex. Brown. He was the industry’s number one oil analyst. Stuart then joined Macquarie Bank in 1999 as head of their mining research team.

Mining Sector

  • In general, mining sector erodes wealth. Given $1 in cash flow created, they return 70 cents and destroy 30 cents in trying to find the next big oil field or mine, until many years down the road they realised that they were just lucky.
  • Over 10 years, oil industry returned 13% CAGR, gold industry returned negative 5% CAGR (despite tax breaks and not having shortage of capital), and extraction companies returned close to 0% (despite being efficient, having low-cost ore bodies, and having a commodity-based currency).
  • Mining companies are price takers, are faced with high ongoing capital expenditures, and high exploration costs.
  • M&A activity is driven by distress and not growth, because of the ego factor. This is in comparison with the oil industry that saw 4 mega-mergers to cut costs during 1999 when oil was US$10-$12/bbl for 3-4 months (Exxon and Mobil, BP and Amoco, Total and Petrofina, Repsol and YPF).
  • A typical junior to mid-cap oil explorer is under $1bn.

Valuation of Mining Companies

  • Reserves
  • NPV. This allows you to put a value on the ore body in the ground, which is a finite resource. Key inputs are
    • Costs of extracting the ore
    • Long-term commodity price. Pick a long-term commodity price that is constant over 10-20 years, or whatever the oil field or mine life is. Historical oil prices were shaped by global growth, recession, OPEC action, technology shift, and wars. Unless there is something new, it is reasonable to use the historical average price (e.g. $19/bbl for oil). In addition, companies don’t react to short-term price fluctuations with long-term commitments.
    • Bond rates. The discount rate used is the 10-year bond rate + 2%.

Mining Stock Cycle

  • Mining stocks are for trading, not for “buy and hold”.
  • Mining cycle is about 5-6 years, with the cycle about 200-300%. It is macro-driven.
  • Two opportunities every 3 years. Try to pick it at the bottom, wait 3 years for the industrial cycle to turn, then sell.
  • Stock prices will be the cheapest when the P/E and P/CF ratios look the worst (i.e. highest).
  • Industrial production drives metal consumption.

Forecasting Commodity Prices

Look at

  • Global industrial production (the way the industrial production cycle is going, and review the last few cycles).
    • Commodity stock levels.
    • Supply/demand balance
    • Bond rates
  • In a typical mining cycle, gold will turn 6-9 months before the mining stocks (e.g. metals), then 3 months later the bond rates starts ticking up, and industrial production starts picking up.
  • Gold is a leading indicator. Uncertainty drives gold, so gold performs in periods in between stability and recession. Gold performed in Aug/Sep 1998 and signalled the start of a mining cycle.

Picking Mining Stocks

  • Small companies
    • For small companies, if they have a good ore body but they do not have the expertise to build and operate, they need to engage consultants or do a JV, and they have a good chance to be taken over (e.g. Anaconda). The time to get out is before they turn on the plant. Any cash flows if not returned will be burnt.
    • The prices for single-mine start-ups peak 3-6 months before the mine starts producing. That is when the analysts have written their research and big funds have bought the stock. You buy on a bet and sell into the certainty.
    • Don’t buy a company when they are about to start production and there is lots of hype.
    • For a small company to go to the next level, they need to invest seriously to grow their staff’s operational and production skill sets, and exploration capabilities. Or they can choose to exit. If they continue to explore without building up, they will destroy capital.
  • Diversified mining companies
    • For diversified mining companies, go for them at the bottom of the cycle. Rio Tinto delivered exceptional returns because it operates like a closed-end asset trust where cash flow was sent to their asset trust board which instilled capital discipline (e.g. objectively considers whether to invest more in an existing mine or elsewhere).
    • Big companies that are down on their luck with stock prices halved can double or triple over a cycle.
  • Speculative companies
    • There will always be stories of a company that is going to drill a batch of wells, and backed by an NTA of say $1, which you can buy for 80 cents. If you make 20% in a week, don’t buy more, sell. Regardless of the NTA, it will go back to 80 cents less whatever they spent.
  • Know where absolute, not relative, value exists.

Advice to budding stock analysts

  • Starting out
    • Start with the easiest stock and make sure you do it better than anyone else.
    • Your first 3 recommendation should be “holds”.
    • Do thorough research, make one call, but get it right.
  • Management
    • John Baillieu’s advice on talking to management, “Treat them all as liars and cooks until proven otherwise.”
    • Companies don’t make bad decisions, only people do.
  • Career
    • You have to enjoy talking to clients and like the people you work with.
    • Don’t go for very highly paid jobs that will be detrimental to your family.
  • Job
    • An analyst can properly cover only 10 or less stocks.
    • Forecasting risk is highest for small companies because their administrative costs are large compared to their profit, so getting the administrative costs wrong by a little can have a huge impact to net profits.
  • Ethics
    • If corporates pressure you to write certain things, if you don’t feel comfortable, don’t do it. If you do it and you made a mistake, it’s a killer that will come back to haunt you because it is your name on the report.
    • Don’t pressure your clients. Always make sure your client gets something out of the relationship.
    • Treat everyone with respect as a human being with a job to do.

Analysing Industrials

Look at

  • GDP growth
  • EBIT margins
  • margin contraction
  • market share gains or losses
  • premium or discount to market multiple


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