The last two years have been a tumultuous time for the mining sector, as falling commodity prices have prompted each of the industry’s biggest players to increase production volumes in order to prop up revenues.
This has merely served to precipitate a supply glut of industrial metals, much the same as has happened with oil, leaving the sector stuck within what looks like its very own ‘doom loop’.
Investors could be forgiven for thinking that this leaves many miners inside value trap territory.
Value trap or value play?
There is reason to believe that the future may not be quite as bleak, for some companies, as the popular narrative suggests. In the absence of expectations for a recovery in commodity prices, diversified miners have almost all announced plans to close mines, or delay investment in order to preserve capital and reduce balance sheet leverage.
So production is now beginning to drop out of some markets with the mothballing or disposal of operations. This could eventually help place a floor under metals prices as supply belatedly adjusts to the new reality of demand.
Moreover, most of the losses reported for 2015 have been the result of record impairment charges. If capital expenditure and other forms of costs are cut sharply over the coming quarters, while commodity prices stabilise, then two things will happen in response.
The number of impairment charges reported in 2016 will be lower than in 2015, which bodes well for profitability, while underlying earnings across the sector could receive a boost from disposal proceeds as well as greater capital and expenditure discipline.
This leaves diversified miners, on average, looking more like value plays than value traps. There is certainly a possibility that, in 2016, the risk for some mining shares will be to the upside.
If I’m right, Rio could be a winner…
Rio Tinto (LSE: RIO) reported operating profits of $3.6 billion for 2015 before finance, impairment and amortisation costs pushed it to a pre-tax loss of $726 million.
In response, management cut the dividend for 2016 and beyond before pledging to cut operating costs by an additional $1 billion in 2016 and $1 billion in 2017. The board will also reduce capital expenditure by a further $3 billion over the same period.
Even before this Rio’s balance sheet was almost best in class, with debt/equity at 0.57x and gearing at 36%. Additional actions from management will bolster this further while also enhancing profitability.
Anglo could be good bet as well…
Anglo American (LSE: AAL) could also be a 2016 winner. The group previously enjoyed a best in class balance sheet until record impairment charges drove a 25% reduction in the equity value of the business.
Today debt/equity sits at 0.98x, while gearing has reached 50%, which means reducing Anglo’s $17 billion debt pile is now an imperative for management. As a result, the board has suspended all dividends and increased its disposal target for the year from $2.1 billion, to nearly $6 billion.
These targets, if achieved, will reduce leverage and risk on Anglo’s balance sheet sharply. If accompanied by an end to further impairment charges, such an improvement could be a source of significant upside for the shares.
It is worth noting here that some analyst price targets imply a return to 1,010.0 is likely over the next 12 months, for shares currently trading at just 460.0.
‘The only way to get rid of a temptation is to yield to it’ – Oscar Wilde, 1890
James Skinner has no position in any shares mentioned. The Motley Fool UK has recommended Rio Tinto. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.