Spheria Asset Managements' head of trading Adam Lund says it is not the next big cash burning lithium explorers they are chasing, but the high-quality free cash flow generative businesses. Pic: Spheria Asset Management
Experts
Money Talks is Stockhead’s regular drill down into what stocks investors are looking at right now. We’ll tap our extensive list of experts to hear what’s hot, their top picks, and what they’re looking out for.
Today we hear from Spheria Asset Management head of trading Adam Lund.
The resources sector is one in which the Spheria Asset Management team is uncovering some very compelling opportunities.
“Surging commodity prices, inflationary pressures and stronger corporate balance sheets have combined to create a perfect storm for resources,” Lund says.
“However, it is not the next big cash-burning lithium explorer we are chasing, rather we are investing in high-quality free cash flow generative businesses which remain widely under-appreciated by the market.
“There is no doubt it makes sense to own resources companies, but in doing so, minimising risk is important,” he said.
“Our investment process is built around finding businesses that make consistently strong free cash flow, have good returns through the cycle, hold strong balance sheet positions, are driven by a quality management team and have an attractive valuation.
“On the other hand, we steer well clear of overhyped companies in the sector with nonsensical valuations.”
One trend that has emerged in the sector is how fixated investors are becoming on short term price moves and events, he said.
“Investors seemingly are not placing as much value on the longer term valuation and fundamental prospects of a business and this is a key market trend that is certainly profound within the resources sector.
“By focusing on mid-cycle valuations and avoiding short term distractions we are better able to exploit dislocations that appear in the market between value and price, allowing us to build positions in high quality cash flow generative businesses that are trading at unbelievably low earnings multiples.”
Lund said the continued economic reopening from COVID lockdowns, an expansionary CAPEX cycle that is starting to gain pace following over a decade of underinvestment, domestic and global infrastructure stimulus, along with the decarbonisation super cycle – are all key trends that will prove to be drivers for the sector in the months and years ahead.
“Deterra Royalties, Monadelphous, and Alumina are three businesses within the resources sector that we feel are under-appreciated by the market today and yet tick a lot of the boxes for an investor that focuses on valuation,” Lund says.
“The common thread between all three of these businesses, other than their GIC classification, is they are all businesses under-owned by the market and in our view the risk/return profiles certainly look attractive.”
Deterra owns a portfolio of mining royalties including a 1.23% royalty on iron ore production at Mining Area C which is majority owned by BHP and has an estimated mine life of more than 50 years.
“Royalties provide an annuity-like income stream, and Mining Area C – the jewel in Deterra’s crown – has a production capacity that is likely to more than double in the next few years which will see investors benefit from capacity payments as the production profile expands,” Lund explained.
“With credit tightening and softening Chinese demand, the iron ore spot price recently moved from a cycle peak of above $230 to below $100 in a matter of months.
“This created an opportunity in the market to get exposure to a high-quality royalties business with no OPEX or CAPEX risk supported by a net cash balance sheet. The volatility in the iron ore price has since slowed and investors are waking up to the high quality nature of what this asset really is.
“It would appear that the old Iluka register holders have moved on to make way for the natural owners of this spun out royalty asset, being like-minded long term investors.”
Lund said Deterra trades on a 6.5% fully franked dividend yield, has strong cash flow conversion and operates on 96% EBIT margin.
“We are also positive on its conservative management team that is on the lookout for complementary royalty assets to build out the current portfolio which will likely diversify its metals exposure.”
This is a high-class engineering group that provides construction, maintenance and industrial services to resources, energy, and infrastructure industries.
Trading on an undemanding EV/EBIT multiple of 10x with a net cash balance sheet and a strong track record of returns this is a business Spheria Asset Management finds difficult to ignore.
“An underinvestment in CAPEX by the miners has created a situation whereby if the miners do not raise CAPEX we risk further shortfall shocks and MND is well positioned to benefit from an extended CAPEX cycle (their strong growing pipeline of work demonstrates we are already starting to see signs of this),” Lund says.
“The business is currently under pressure with the WA border closure limiting the access of interstate and offshore workers which is driving labour cost inflation and restricting project commitments.
“Given how the current COVID induced environment is being capitalised in the share price, we believe a great buying opportunity has emerged.
“We remain firm in the view that the political tangle that has been created will at some point rectify and the environment will improve, driving the MND share price.”
Alumina through its 40% interest in Alcoa World Alumina and Chemicals engages in bauxite mining, alumina refining and aluminium smelting businesses.
AWC is a first quartile cost producer with a world-class bauxite resource strategically located within close proximity to company-owned refineries and has access to an oversupplied natural gas province in Western Australia.
“With the Alumina price stabilising and input costs including energy, labour, bauxite and caustic soda prices moving higher, Alumina is well positioned to benefit from the world returning to some kind of normality,” Lund said.
“We think aluminium is an under-appreciated beneficiary of electrification efforts. Transmission build outs directly increase aluminium demand and the light weighting of electric vehicle bodies with aluminium is gaining increasing impetus because of the inherent range and weight issues associated with batteries.”
He said with so much focus on decarbonisation from governments and the wider community, AWC’s greenhouse gas intensity is half that of its industry average providing significant upside, particularly with the prospect of carbon pricing putting long term margins under pressure.
“To top this off there is the likelihood that copper substituting increases as the copper/aluminium price ratio widens which should prove to be a further tailwind for the business.”
Stockhead does not provide, endorse or otherwise assume responsibility for any financial product advice contained in this article.
