The Australian Fund first ventured into mining services in 2013, and the results since have been poor. Shares in mining contractor Macmahon (MAH) were selling for a third of our original purchase price by February. Hughes Drilling (HDX), which provides production drilling for coal-miners, saw its share price fall by nearly 70% after our first purchase. It has since doubled but, even after buying more shares at lower prices, we are still slightly under water.
With the exception of some healthy fully franked dividends from Brierty (BYL), there aren’t any counterbalancing big winners in the sector as yet, either. We’ve asked ourselves whether continued investment is justified and have done a full review of our investments and the wider sector, including some miners. The answer is a resounding yes.
On average, mining is a tough business. In terms of the sheer extent of value destruction, the junior miners are the worst of the bunch. Management act like poker machine addicts—the next big jackpot is always just around the corner, so cash rarely stays in the bank for long and almost never gets paid out as dividends. It is mostly gambled on losing bets.
One percent of miners hit the jackpot, the rest run out of cash and return to shareholders for more money. We continue to keep an eye out for value, but other than South32 (S32) at the larger end of the market, we haven’t found much to invest in.
The service providers too are a mediocre bunch. In favourable circumstances they can mimic good companies, but when conditions deteriorate they are usually shown to be cyclical beasts. As investors in United Group (UGL) and Forge Group (FGE) would know, profit is often earned by taking on risks that aren’t apparent until the company is battered by them.
Our experience to date, particularly with Macmahon, gives us further reason to be wary. The first purchase of shares in the company was two years ago, just prior to it reporting $1.3bn in revenue for the 2013 financial year. It was obviously going to shrink, but we had pencilled in $700m per annum as a sustainable amount of revenue. That number turned out to be wildly optimistic: for the coming 2016 financial year it could be less than $300m. The company has failed to renew every contract that has expired, hasn’t been able to land one new win and had an important long-term contract with Fortescue cancelled.
But from our review we’ve concluded, despite the mediocrity, there’s remarkable value in the service providers. A few of them are better quality then they look. But for the most part it’s because, as the commodities boom has faltered, share prices have plummeted. These businesses are average, but not this average.
They are also less risky than they were two years ago. Having closely watched the sector for two years now, we are beginning to see the operating results of companies progressing through the difficult business conditions. The results aren’t pretty, but they aren’t catastrophic either, and our conviction is strengthening that the value here is real and hugely mispriced.
Even our friends at Macmahon have managed to pull a rabbit out of the hat. Its Mongolian business – on care and maintenance since the Mongolian government stopped paying the bills in August last year – has been sold for net proceeds of US$63m, or approximately 6.5 cents per share (compare that with a pre-announcement share price of 4.6 cents). We need to make sure the rabbit doesn’t run off into the bushes (the CFO seemed reluctant to discuss the best way of returning this cash to shareholders) but, now that it has more cash in the bank than debt outstanding, it is hard to see it ending in disaster.
The story is similar across the sector. At these prices, many service providers in the Australian Fund will likely produce more cash flow in a just a few years than their current enterprise value. Others trade at a fraction of their liquidating asset value. Some have both huge earning yields and sell at a discount to tangible assets, increasing the protection.
Having swept the sector, here’s a summary of our best picks and the opportunity as we see it. Any one of these businesses could have a tough run, and it’s highly likely one or two will. But together the combined earning power, cash generation and asset backing for each dollar invested is very impressive. It’s as exciting a bucket of stocks as we’ve ever had in the portfolio.
In his 2009 report to Berkshire Hathaway shareholders, Warren Buffett said: “Big opportunities come infrequently. When it rains gold, reach for a bucket, not a thimble”. The Australian Fund has topped up in the best on offer, and our bucket is out and ready to collect.
Despite the drag from mining services, the past 12 months have been excellent for the Australian Shares Fund, with an investment returning 12.3% versus the 5.7% return from the index. Pregnant with opportunity at the moment, we are hopeful of even better to come.
This was an excerpt from the June 2015 Quarterly Report.
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Forager Funds is a boutique fund manager specialising in a value investing approach. We offer an ASX listed Australian Shares Fund as well as an International Shares Fund both aimed at delivering returns for long term investors.