Should investors hold equity in miners or should they hold the physical commodity in their portfolios?

This may sound like a moot point, but it is currently quite pertinent.

If you held an ounce of gold for a hundred years, you would still just have an ounce of gold. If however you held Anglo American plc shares for a hundred years, you would have a number of other unbundled shares and a (more or less) steady flow of dividends as the group diversified into new commodities and new territories. And you would still have your shares in Anglo.

But for every Anglo American, there are plenty of lesser miners – and if you had bought their shares over the course of the past century, all you would be left with is an expensive hole in both the ground and your brokerage account.

Risk in perspective

Simplistically, mining is risky – and once the commodity has been dug out of the ground it is therefore less risky. But mines are fixed-costs businesses, and any change in the price of the commodities they dig up and sell will have an exaggerated effect on their bottom line (revenue changes but costs do not).

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Surely, if you are bullish on a commodity, then hold shares in the miner and you will get geared upside exposure to it?

Yes and no. There are nuances here, with the most notable and pertinent two being: inflation and mining-related risks.

Source: The author

In between a miner’s revenue and its profits lie its operating costs. And, like all businesses, these costs can be subject to inflation. Spend some time looking through all-in costs reported by miners recently and you will see that despite strong commodity prices, miners are having to absorb higher and higher energy, steel, chemical and labour prices.

A physical commodity is not subject to inflation. In fact, inflation can help boost its price.

So who wins? Miners or their commodities?

Let’s not guess, let’s inspect some of the facts … 

Two very different pictures start to emerge, as gold miners still lag their own commodity while platinum miners are comfortably outperforming theirs.

As South African gold deposits get deeper it gets more expensive to mine them, which makes gold mining more susceptible to inflation. This explains Gold Fields’s outperformance; it was early to move offshore and, particularly in Australia, opened up excellent new ore bodies.

On the other hand, platinum miners aren’t really platinum miners. They mine a basket of platinum group metals (PGMs), and palladium and rhodium have to be included here. Both these metals have had such strong runs in the last couple of years that they contribute large amounts to these miners’ revenues and profits. When you track these same shares against rand-palladium and rand-rhodium prices, they underperform the physical.

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More subtly, as Sibanye-Stillwater’s gold strike is looking to spread into the platinum belt, PGM production could stall and/or wage inflation may be reset higher.

Both are negative to the miners, but positive for the metals.

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Without Russian supply, South Africa is by far the world’s major PGM supplier – and tight supply is, ironically, positive for the underlying metals prices.

Source: The author

And – contrary to our earlier example of holding Anglo American for a century – in these ways, commodities can outperform the miners.

Like I said, nuances …

A rough guide

In summary, and ignoring exploration/production plays (see Renergen as an example), the following rough guide should help your decision-making in this space:

• Commodity bear: If you are bearish on a commodity, hold neither it nor those that mine it. Neither should benefit here.
• Cost pressures and supply challenges: If you are bullish on a commodity but see high(er) inflation and/or mining-related risks/supply shocks, consider holding the physical over the miner (unless you can find a low cost-curve miner with low-risk production).
• Commodity bull: If you are bullish on a commodity and not worried about inflation or mining-related risks, then consider holding the miner over the physical.
• Uncertain but want to participate: Consider not investing in either miner or commodities. Rather consider investing in those companies that supply them, such as Master Drilling Group (Read: Expect the lights to be shot out).

Bonus chart

I’ve indexed the Sasol share price to the rand-oil price over the last decade. Yes, Sasol is more a chemicals play and, yes, it is not really an upstream oil and gas producer. Still, you would have been better off buying oil than Sasol …

Source: The author

Keith McLachlan is investment officer at Integral Asset Management.