by EV Y HAMBRO

A long-term resource for growth

FOR PROFESSIONALCLIENTS ONLY

After a torrid start to the year for the gold and mining sectors, BlackRock investment writer James Pexton caught up with the firm’s renowned Natural Resources CIO, Evy Hambro, to learn more about why their longer term outlook remains positive.

What has happened in the mining sector so far this year?Despite global equities enjoying a period of relative strength at the start of 2013, mining and gold equities have failed to keep pace. Much of the tailwind for global equities has come from the nascent economic recovery in the US (and resultant US dollar strength – a headwind for commodities), a period of less dramatic newsflow from Europe and improved investor sentiment. However, mining equities have been challenged by a greater focus on sectors with exposure to a recovery in US markets rather than emerging market (in particular Chinese) growth, and some high-profile changes in the management of major mining companies, accompanied by major writedowns in book values of recent acquisitions.

The focus is now on these new management teams, and whether they can persuade investors that they will not make similarly poor investment decisions and can prove that capital discipline in coming months and years will lead to better returns for shareholders.

Gold equities in particular have fallen sharply. Why is that?The FTSE Gold Mines Index has fallen by 16.9% YTD1, compared with a 4% fall in the bullion price, while general mining equities are down by 14% (according to the HSBC Global Mining Index). This underperformance is partly because bullion has trailed other key commodities,

with WTI oil rising by 6% and Brent crude down just 2%, and the bulk commodities having posted gains over the year so far. Another factor has been the negative tone of fourth-quarter results, with a number of companies guiding expectations for 2013 (and sometimes beyond) below market expectations.2

Ultimately, these forecasts now appear more realistic than some of the ‘heroic’ forecasts gold companies have previously made.

One of the things we have been stressing for some time is that gold companies need to be disciplined and deliver on promises if they are to see their share prices rewarded. We believe this lower guidance is evidence of a more disciplined approach to project and capital management which ultimately should prove to be a positive for the sector. However, we note that some gold companies are using aggressive gold price assumptions in their business planning and we prefer those companies that adopt a more conservative approach as it builds greater flexibility into the business.

You mention more discipline in terms of project and capital management. What do you mean by that? We are starting to see lower operating cost across both sectors, so the rate of cost inflation has declined materially over the last couple of years, which will ultimately be to the benefit of company margins.

A long-term resource for growthby EV Y HAMBRO

2 | A LONG -T ERM RES O UR CE F OR GR OW T H

EVY HAMBROCIO of BlackRock Natural

Resources Equity Team

1 Source: FTSE Gold Mines Index.2 Source: BlackRock. All data in

USD terms as at end March 2013.3 Source: CIBC, November 2012.

In addition, costs are being cut very aggressively by a number of companies. Take Rio Tinto for example, which has outlined $5bn of costs to take out of its business, while BHP Billiton has taken out just under $2bn of operating costs in the last six months. The reduction in these costs is easing pressure on the system – we are now seeing those companies with growth projects coming to us, saying they are being offered mills and trucks at prices substantially below their cost of manufacturing.

Currencies are also moving in the companies’ favour. The Australian dollar is starting to weaken, while the South African rand is also down; all of which will be positive for resource company margins.

But when will the much-heralded, and much delayed, re-rating of gold equities towards the price of bullion happen? Obviously we’ve seen gold shares underperform the price of gold now for the last couple of years, but the rate of underperformance appears to be reducing.

Gold equity valuations today are a fraction of where they have been in the past. That’s been driven by a combination of things – cost increases weighing on margins, the lack of production growth and the way the companies have been run. Gold ETFs also provided an alternative to weakness in gold valuations. Gold shares have also not been competitive in terms of producing yield in what is an increasingly yield-hungry market.

But things are changing – the yield issue is being addressed, capital discipline is improving and margins should start to do the same. We believe all of the necessary actions are now being taken – this is what gives us confidence that things are starting to get better but is it going to be tomorrow or over the next six months or so? That is the hard part to answer.

Which areas of the market do you currently favour?Our bias in the portfolios tends to be towards the mid-cap, higher growth companies and underweight the large-caps. That’s particularly the case in the gold portfolio where we are significantly underweight large-cap producers given the likelihood they will

continue to struggle to replace ounces in the future at the same margins.

Staying with that theme for a moment – At what level does a falling price for the physical asset become problematic for the margins of the gold producers?One of the things we have seen recently is the disclosure of ‘all-in costs’ by the gold mining companies. This is setting expectations that the break-even level, including sustaining Capex, needed for the sector is somewhere between $1200 and $1400/ounce.3 That is where you may start to see gold companies not only cancel growth projects (which is happening already), but actually take production out of the market, which would obviously be very supportive of prices.

I believe the downside risk in the price of gold is limited. In fact, many gold companies need higher prices than we’re currently seeing in order to stay in business, so they’re really at this marginal pricing point. That is very exciting and is, typically, a good time to take on an exposure to the sector. Clearly, that doesn’t apply to all gold companies but with the cost curve so heavily weighted to the higher cost producers it is actually a key point to be looking at gold equities.

Is the commodity bull run over? Can investors still make money in the sector in 2013 and beyond?In the near term (2013) there is the potential for a recovery in risk appetite as the macroeconomic environment improves, downside risk diminishes and people switch out of fixed income back into equities. This is likely to provide momentum to those cyclical sectors that have suffered over the last two years as the market has downgraded global growth expectations. Despite short-term issues, this should ultimately be of benefit to the mining sector, perhaps most obviously among smaller-cap, higher-risk names.

In the medium term (over the next two years), we see commodity prices remaining relatively strong, but range-bound as a result of a more balanced supply-demand situation. This means that the major mining companies will have to focus more on capital discipline, operational efficiency and growing margins through cutting costs rather than through commodity price appreciation. Free cash-flow generation

should therefore be very high and we could see returns to shareholders increase. Among smaller-cap stocks, the focus will be on those companies that can deliver growth in volumes into this strong, but not necessarily rising, commodity price environment. The potential for M&A activity is greater here than among the larger-caps as companies seek to consolidate and add to their growth profiles. Financing will still be an issue for many of the developers, so those companies that are able to fund that growth profile or have such a high quality of project that they should be able to get funding, either through strategic partners or by being acquired, will outperform.

Whilst we do not believe the “super cycle” is going to return in full force this year, in the longer term (three years or more), we see some tightness returning to commodity markets as the decisions being made today to postpone or cancel growth projects by the likes of BHP Billiton mean there will be a lack of significant supply growth from 2015 onwards. This suggests that those commodities that could move into deficit (copper, zinc and potentially gold) should perform strongly.

Ultimately, this is a market in which specialist, stock-picking investors should flourish.

Why should investors go down the active management route when it comes to natural resources? In an environment where supply-and-demand dynamics are not uniformly attractive, being selective on individual commodity exposures is critical. Companies have the ability to add to or detract significantly from shareholder value by investing in projects that can generate a rate of return in excess of their costs of capital or that can fail. We believe active management is best placed to single out those companies that have the underlying asset base, the right management team and the appropriate balance sheet to support such ambitions.

Importantly, it can take time for this value to be realised – mines are long-term assets both in terms of their development period and their operational lives. This is one of the key reasons why the natural resources team adopts a relatively long-term investment horizon when assessing natural resources assets.

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