Professional Investor: Mining for good value in a long-term supercycle

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The Independent Online

Lack of supply and excess demand for commodities has made it clear to me that this is more than a normal cyclical bull market. This is apparently the beginning of a long-term secular bull market, or "supercycle", and, as such, we have taken an overweight position in mining stocks to benefit from the overall upturn in commodity prices.

Despite fears that commodities have peaked, I believe that the global demand for raw materials will grow. High demand has been mainly driven by China, a country in which economic growth is perceived to be slowing down, but the implications of demographic growth are overlooked. I believe that markets have underestimated the scale of industrialisation in China, a hitherto agricultural economy.

China's situation is similar to America's in the early part of the 20th century and Britain's in the mid-19th century, in that both countries experienced periods of economic growth. As a result of the above, forecasts are underestimating the level of commodity prices going forward. In June, prices were even lower than now. When companies had their results in the latter half of July and August, mining share prices went up significantly as a result.

The pace of urbanisation in China is becoming an important trend because of its industrial revolution. We are seeing an increased demand for housing and infrastructure in its cities. Real-estate players and construction companies will benefit as a young and better-off population looks to improve its quality of life. Urbanisation and changing lifestyles are transforming the way China eats, shops, relaxes and enjoys itself.

The infrastructure and industrial development of China (and India) have led to an enormous demand for primary energy. After the US, China is the largest global producer and consumer of coal, steel, cement and non-ferrous metals. Its continued power shortages (20 million people - equivalent to the population of Australia - have no access to power) and other infrastructural bottlenecks, such as congestion at ports, traffic jams, inadequate rail infrastructure and a poor transmission and distribution network (20 per cent transmission losses), mean that investments in these sectors will have to continue at high levels.

Commodity cycles do not normally last long. The main difference now is that the lack of supply is continuing for longer than most analysts expected, coinciding with heightened demand. Companies cannot find economically viable mines in which to invest, because of depleting resources. Criticism is also directed at companies for not trying to find new areas to explore, thus fuelling the shortage of supply. Other issues have arisen from more politically sensitive areas, such as the Russian satellite states, and some African countries, where mining companies are increasingly operating.

One way, however, that mining companies are growing their business is through acquisitions, and there is currently lots of activity within the sector. The London-based mining group Xstrata lost out to BHP, the UK's second largest mining company, when it made a successful bid for South Africa's WMC Resources in March.

Subsequently, Xstrata has taken a 20 per cent stake in Falconbridge, the Canadian nickel and zinc miner. But in the last fortnight Inco has made a bid for Falconbridge, thwarting Xstrata's ambitious expansion. This increased corporate activity highlights how difficult it is for mining companies to grow organically by finding and developing new minerals and ores. I believe, therefore, that corporate activity is set to continue because valuations are attractive, given the continuing good prospects for attractive returns.

Claims of a mining "bubble" are wide of the mark. Analysts have already begun to upgrade their forecasts. And to those who question if it is just like the tech bubble, the answer is that the cycle is set to continue for much longer. Lack of supply, for one thing, does not apply to technology. With low multiples and low valuations, Xstrata, for example, is trading at a 30 per cent discount. We feel commodity prices will remain strong, and expectations in the market do not reflect this.

The technology bubble was characterised by absurdly high valuations for what ultimately proved to be a cyclical industry. In contrast, the miners' quotes on the LSE trade at significant discounts to the market, reflecting their previous history of the boom and bust cycle. But I think the bull phase of the current cycle is set to continue for a while yet, and that the current share prices still offer excellent value.

Ted Scott manages the F&C UK Growth & Income Fund


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