By Investment Contrarians
A friend of mine recently asked me a question that many others might be asking as well: why do mining companies swing so often from optimism to pessimism?
If we take a look at how the mining companies have reacted to price over the past few years, we can see just why there’s so much volatility.
Like any rational person, the people who run mining companies want to maximize revenues and earnings; that’s their main investment strategy. As the prices of commodities increase, each individual firm looks to produce greater quantities to take advantage of higher prices.
This seems like a solid investment strategy—except that if each of the mining companies has the same idea, the net result ultimately is an increase in supply to a level that’s greater than the market can handle—which depresses prices.
Obviously, we can’t have mining companies work together to set prices; that’s called collusion and it’s illegal. But as a potential investor, you want to see the management of these firms take a pragmatic view of the environment.
The recent write-down of billions of dollars and the reduction of mine expansion is actually a good thing for shareholders. The investment strategy right now has shifted from trying to produce as much as possible, regardless of the cost, to maximizing cash flow and, ultimately, profits.
Mining companies need to rein in reckless spending and expansion to focus on creating shareholder value. The investment strategy of only focusing on the lowest-cost mines and highest margins is a positive step for this industry.
For far too long the management personnel at many mining companies have gotten lazy and relied on ever-higher prices of commodities to cover up their escalating costs. This is no longer the case.
For example, while it is true that copper prices have rebounded slightly, mining companies can’t assume that previous highs will be reached. Because of this, the investment strategy has to be more focused and regimented.
If the supplies of commodities begin to decrease and match demand, over the long term, mining companies could create a substantial amount of shareholder value. But this investment strategy has to be maintained.
The problem is that if commodity prices move higher, we could, yet again, see overpriced buy-outs of assets and overproducing, which leads, yet again, to the boom-bust cycle. This is why we see volatility in mining companies over the long term—it’s the constant overproduction to try and gain revenue growth, which leads to oversupply and a crash in prices.
One of the themes I’ve discussed in this column before has been to focus on the management of mining companies. Does the company’s investment strategy make sense for the long term, or is it’s management personnel simply looking for a quarter or two of improving financials to get the stock price up so they can take profits?
Look for mining companies that have a management team who own a significant stake in the company, as this will align their investment strategy with yours.
While the pain has been severe for mining companies this year, if the firms can restrain spending and expansion plans to focus on high-margin assets and producing a sensible amount of supply, we could see solid returns over the long term. But this investment strategy will take a long time to work itself out, as the current level of supply needs to be absorbed—patience will be needed.
~ by Sasha Cekerevac, BA
This article was originally published at Investment Contrarians