In the first in a series introducing Perpetual Asset Management’s Australian Equities team, we chat to Clarke Wilkins, Senior Equities Analyst, responsible for the resources and energy sectors. Clarke joined Perpetual in July 2019 and has extensive experience covering mining and energy companies as well as global commodity markets. Here he offers insights into these sectors, the Perpetual investment process and the factors shaping his own personal investment philosophy.
With reporting season behind us, can you give us a few general thoughts on the resources sector in Australia?
The resources sector in Australia really needs to be broken down into the mining sector and the energy sector as the reporting season and investment thematic for the two of them are quite different. The mining side of the equation saw a strong reporting season driven by commodity prices, especially iron ore and gold, and very strong cash returns to shareholders driven by the free cash flow generation and bullet proof balance sheets. On the energy side of the equation, oil prices were much more impacted by Covid, until recently, and considering the balance sheets, were much more leveraged going into the pandemic, which has resulted in a very different outcome. Some stocks in the sector have had to raise equity, with cash returns to shareholders far more modest as they have had to build up reserves to fund capital-intensive growth projects going forward.
There are plenty of compelling stories within the sector. What trends are you following and where are the clearest themes?
The mining sector loves a thematic! Over the 20 years I've been doing this, there is always a thematic and we’ve seen both a strong copper and nickel thematic. But in the last few years, lithium has clearly been a major thematic on the back of the global electrification of the automotive fleet. That took a brief pause during Covid, partly because too much capacity got built when prices rallied to record levels, but also because demand clearly got impacted in the initial stages of the pandemic. However, it’s come back surprisingly strongly and, if anything, the push to electrification has accelerated rather than decelerated right through the pandemic. Despite the strong demand, lithium stocks really don't meet our investment process in terms of generating earnings through the cycle as well as the leveraged balance sheets that drove a number of them to do dilutive equity raisings in 2020. For us, copper and nickel are parts of the electrification equation where it is more investable in terms of companies generating earnings through the cycle and also having strong balance sheets.
China controls 80 per cent of the rare earths market but you believe local companies are well placed to benefit from this global megatrend. Why?
Rare earths mine production in Australia to date has largely been limited to Lynas, who then do most of the downstream processing in Malaysia. However, Lynas are being forced to move part of the processing from Malaysia back to Australia due to license requirements around radioactive waste storage, which will involve significant capex. One of the stocks we hold in a number of the portfolios is Iluka Resources, which has recently entered the rare earth market to supplement its existing mineral sands business. Iluka has already started shipping some of the raw materials that go into producing the key rare earth elements (REEs) that go into battery magnets through producing a concentrate from stockpiled tailings in Western Australia. The next stage involves further processing to sell monazite (a mineral that contains REE’s) and there is a feasibility study underway to construct Australia’s first REE refinery that would fulfil the Government’s strategic aim of producing these critical minerals in Australia. In each of these stages they significantly increase the amount of value potentially captured in the value chain.
With Iluka, would it be fair to say that there is a strong base case and any rare earth addition to operations would be the “cherry on top”?
Exactly. If you look at Iluka currently, it's basically half split between zircon, which is mainly used in ceramics, with the other half of the revenue coming from titanium dioxide feedstocks, which go into paint and a number of other applications like paper and sunscreen. Rare earth supply would effectively give a third leg to their business case − potentially in the second half of this decade – along with the zircon and titanium feedstocks businesses. However, for the rare earth supply opportunity to get to that level, various components need to fall into place. One is the rare earth refinery in Western Australia, which is commercialisation of an old tailings area that they have. It is very likely the highest-grade rare earth mine in the world. So that's stage two of the project that they're working on now. The next stage to get to that “third-of-revenue” model would require development of the Wimmera deposit, which is a new mineral sands project in Victoria. That project is partly rare earths, but also produces zircon as well as some titanium feedstock.
OZ Minerals has along with Iluka been a top contributor to Perpetual's Australian equities funds this year. Take us through the investment opportunity and this company’s performance to date?
Oz Minerals was a clear example of an opportunity that presented itself during Covid. It was a stock we had been watching for a while, but it had seemed a bit too early to invest for us. This was partly on valuation and partly because of the risks around the commissioning of their Carrapateena project – a large copper mine under development 100 km southeast of Olympic Dam in South Australia's Far North region. But the key thematic in 2020 was the sell-off in commodities during Covid and the valuation started to look very attractive. And then secondly, as we progressed through 2020, there was a de-risking of the Carrapateena mine as construction progressed. Once the mine and the associated infrastructure for that project was completed it significantly reduced the risk of investing in the stock. As we were talking about with battery materials earlier, copper is a key component in the electrification of vehicles. So, there’s the amount of copper that's required in electric vehicles, as well as for wind generation, as well as for batteries. For these reasons, we quite like the copper thematic, and it was an opportunity to buy OZ Minerals at an attractive discount to valuation. The other key component was that OZ Minerals took the opportunity during the initial Covid uncertainty to process and high gold grade parts of the ore stockpiles when gold prices were at particularly high prices. Gold was effectively a by-product credit for them in terms of their copper cost base. This drove a significant reduction in their cash costs.
Can you take us through the investment process: how a company shows up on your radar and how it potentially works its way to “rank one”?
There's probably 60 stocks within the mining, energy and utilities sectors that I look at. At any one time, there's probably only 30 of those that make it into the investment universe as we define it. This is particularly important for the mining stocks, where we’re looking for at least an eight-year reserve because we want to invest in long-life assets, so that you're not trying to time a cycle necessarily. It's partly mine life that narrows our focus but also around gearing being within our parameters, or a clear pathway there. And then there are ESG components, particularly around the sort of governance we see from boards and management. There’s always a watching brief across the whole sector, but there’s a small number of stocks that you're focussed on at any one time.
What sort of companies do you personally like to focus on?
The stocks that I like are where there's opportunity; things that have been mispriced by the market. An example would be the potential for a demerger that we saw with Iluka when they demerged their Deterra iron ore royalty. Effectively one plus one equalled more than two, because the market wasn't valuing that iron ore royalty correctly within Iluka. There can also be opportunities where projects are carried at too high a risk by the market, and if we get closer to production then they generate cash flow and the market can rerate those stocks. More broadly, there can be periods of time when commodities are simply out of favour and the market puts these stocks at a substantial discount to valuation. There is a lot of mean reversion that goes on within commodity markets, which creates opportunities. And then inherently, as part of the sector, there is a big macro overlay. A rising tide lifts all boats, and even though we're fundamentally stock pickers, you need to be aware of the background macro environment because there will be opportunities when the sector will trade at premium to valuations for an extended period if we sit in a period of highly elevated commodities, because global growth is accelerating. Fundamentally, it's about valuation, but you've got to recognise that that valuation can move over time, given the macro backdrop, and the underlying commodity prices.
WA is of course quite accessible for you to be able to get out and see mining operations for yourself and meet the management. But there's also a global component and associated geopolitical risk with some mining companies. How is this factored into your analysis?
Generally, we don't carry a lot of geographical risk in the portfolio. OZ Minerals has a small exposure to Brazil, Iluka has a small exposure to Sierra Leone in Central Africa and inherently, BHP and Rio have South American exposure as well from their copper assets. With the bigger, larger diversified stocks, it's sometimes hard to avoid that geographical risk entirely but of course we try to assess that. There is inherently a safety in investing in a geographically safe country, so gold stocks that are Australian based will generally trade at a premium to an African gold stock. The political environment as well as the fiscal stability and the ability to get people into a country; these are all much, much easier in Australia. That is the reason why the market is prepared to pay a premium for companies in “safe” jurisdictions like Australia. That said, if there is a strong investment opportunity somewhere that has a higher geographical risk, than you have to assess that as part of the investment case. For example, Oil Search has its main assets in PNG, with emerging assets in Alaska. There is a whole lot of risk assessment we will do on the risk around PNG, the influence the Australian government has in PNG, the ability of the company to execute an expansion and who is managing the project as a joint venture partner. So, it's not like we won't take geographic risk, it just has to be assessed as a risk factor as part of the investment process.
You recently visited some mine sites in WA. What was the impact on the ground of Covid and associated business disruption and is it largely back to business as usual?
Australia arguably handled the pandemic better than any other country in the world. And Western Australia probably handled Covid better than any other state with Australia as a general comment. There was some initial shift changes and transportation challenges around Covid in Western Australia, but there has been no discernible impact on production from any of the mines. In some cases, production was prioritised over growth projects, which is a trend that probably applies across the mining space in terms of the Covid impact globally. But to answer your question, WA has bounced back, and mines are basically operating as normal. The tightness we see is mainly in the labour and the contracting market, given there are still some mobility issues in getting people in and out of Australia and the uncertainty of spot lockdowns. Some specialist mineworkers come from New Zealand, particularly with the drill rigs, so getting access to the drillers is probably more the issue than getting access to the drill rigs as a lot those operators do come from New Zealand. Ultimately, it's nothing that can't be managed.
Finally, can you give us a sense of your own personal investment philosophy. Any great piece of advice or formative investing experience that stands out or stuck with you?
I suppose every time you make an investment there is a lesson to be learned. There's definitely lessons in selling assets too quickly and underestimating where asset values can get to in the peak and trough of the market. I invest in the mining sector personally, but I tend to focus more on the exploration side of the equation, so it doesn't crossover in any way with what Perpetual does in terms of an investment philosophy or within the portfolios. It's obviously high risk, but it's also where you can add significant value. Everyone says that all the easy deposits have been found in Australia and there’ll be no further major discoveries and yet, every year, we're still getting some significant discoveries. In Western Australia in the last 12 months there have been a couple of significant gold discoveries while Chalice Mining unveiled a new greenfields mineral discovery just 70 kilometres outside of Perth. This mine could end up being a significant supply of palladium, a commodity that Australia really hasn't produced before and one required for the hydrogen revolution that is getting the market very excited at the moment. It shows that major discoveries are still out there to be made in Australia.
Find out more about the Perpetual’s Australian Equities strategies.
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