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OPINION

Pouring, not raining

Pouring, not raining
April 16, 2015
Pouring, not raining

The people at Chilean copper miner Antofagasta (ANTO) know all about this. Three of the group's four major copper mines are in the Atacama and production has just been disrupted by localised flooding. This was the latest instance - this time literally - of it never raining but only pouring on the group's fortunes. And the metaphorical sequence of downpours means the Bearbull income portfolio has taken a bath on its holding in Antofagasta and prompts the thought that the shares should be dumped because the logic on which they were bought no longer holds water.

At least the rains have stopped in the Atacama. Antofagasta reports that production at its Centinela, Antucoya and Michilla copper mines is back to normal and the lost output may be recouped during 2015. Less likely to be made good is the 8,000 tonnes of production lost at Los Pelambres, Antofagasta's biggest copper mine, which is in central Chile. This was caused by local protests at the enormous demand for water from the mine's processing plant and it added to the effects of a court decision in March that ordered the Los Pelambres mining company - 60 per cent owned by Antofagasta - to demolish the wall of a tailings dam in the Los Pelambres complex.

At the best of times, any tailings dam is a filthy waste dump, hated by local people and a cause of major clean-up costs for a mining company. Whether the situation at the El Mauro tailings dam is much different from the norm, I can't say; but clearly Antofagasta can do without persistent disruption to the mine that brings most of its profits. On copper production of 391,000 tonnes in 2014 (against a group total of 705,000 tonnes), Los Pelambres generated $1.34bn (£900m) of operating profit (against a group total of $1.64bn).

These company-specific difficulties come against a soggy backdrop for copper prices. With demand restrained and global production capacity ramping up, the expectation is that copper prices will remain around the current level of $2.80 per pound for some years. That's markedly less than the $4.63 at which the price peaked four years ago, but history shows that 2011's prices were the exceptional ones. Spot prices for copper have averaged $2.36 since the turn of the millennium.

A continuation of current prices wouldn't be great for Antofagasta, but it would hardly be disastrous. That statement depends on production costs remaining around their current level - Antofagasta's management expects them to average $1.40 for 2015. Assume that will continue and the gap between costs and realised prices remains attractively wide.

If all that holds good, then a resumption of dividend growth will depend on Antofagasta's level of output. For some years now, and especially in the past two, Antofagasta has spent aggressively on its capital account - almost $3bn in 2013 and 2014 combined when cash flow from operations, but before capex, was only $3.5bn. On the one hand, that combination of weakened operating cash flow and heavy capital spending (see the table, 'The changing face of Antofagasta') put too much pressure on Antofagasta's dividend and management responded with a 77 per cent cut in 2014's payout compared with 2013. On the other hand, the aim - and the hope - is that the company's aggressive capital spending will add anything up to an extra 200,000 tonnes of annual copper production by 2018.

In other words, Antofagasta's merits as a low-cost supplier with lots of financial strength - even after all this capital spending it still has just a tiny amount of net debt - stands it in good stead in the long run. So, if I were running an all-purpose equity portfolio, its shares would look like a plausible recovery situation. But in the short term the Bearbull income portfolio has to deal with the reality that, on the current share price of 732p, 2014's payout generated a dividend yield of just 1.9 per cent and the dividend probably won't be much higher this year.

Much as I would like to keep the Antofagasta holding, it is difficult to justify its inclusion in an income portfolio. Clearly there is no point in selling before the shares go ex-dividend next week, but thereafter Antofagasta's days in the fund must be numbered. That they won't be sold immediately after the ex-dividend date is more a comment on the fact that the fund has been in need of a new holding since I sold its remaining stake in Carr's (CARR) - the former Carr’s Milling Industries - in January and there are several other holdings with which I am unhappy.

 

The changing face of Antofagasta

 Copper productionRealised priceCash costsFree cash flowCost of dividends
 (000 tonnes)$/lb$/lb$m$m
2009442.52.710.96-317231
2010521.13.591.046631,144
2011640.53.731.021,800434
2012709.63.661.031,974971
2013721.03.281.36371937
2014704.83.001.43176212
2015E710.02.80*1.40

Source: Company, * current market price

 

Then again, my unhappiness may be as much to do with the overall dull performance of the income fund as with some individual holdings. It was ever thus. When a fund performs well - whatever the reasons - we believe ourselves to be great stock pickers. When performance goes into reverse then we lose confidence, become hypercritical and doubt our ability to make a good investment call ever again. I exaggerate, but you get my drift.

A bit of perspective is needed. The first point to grasp is that these are not great times for 'value' investing, of which generic type an income fund is just a variation. In fact, value has been underperforming growth for much of the past five years. Taking April 2010 as the start point, then the 'value' version of the MSCI Europe index has gained just 11 per cent, while the 'growth' version has risen 39 per cent.

Given that this has been a period when the 'search for yield' turned into an obsession, this underperformance may seem odd. After all, the reliability of dividends churned out by the likes of HSBC (HSBA), Royal Dutch Shell (RDSB) and Vodafone (VOD) - all stalwarts of the MSCI Europe Value index - is sufficient to make their dividend yield of 5 per cent or thereabouts a serious alternative to a 'high' yield savings account that produces barely more than 1 per cent. Whatever the merits of that logic, it has not translated into share-price action. Presumably the attractions of economic recovery - however feeble to reality - has trumped the dull reliability of a steady income stream.

That's the backdrop against which the Bearbull income portfolio has laboured. But it may have developed issues of its own. The portfolio's value peaked at just over £311,000 in February 2014. Since then, its value has declined 7.9 per cent. Yet over the same period MSCI Europe has dropped just 2.7 per cent, while the FTSE All-Share index has risen 4.4 per cent and MSCI Europe Growth has gone up 5.7 per cent. So the Bearbull income portfolio - so long the leader - is now a laggard; not disastrously so, but of sufficient distance and duration to ask whether there is something wrong with the portfolio.

True, I have asked this question before and concluded that - actually - the balance of the portfolio is much improved since I reduced its dependence on FTSE 100 companies and increased its exposure to small-caps via the purchase late last year of shares in Record (REC), Air Partner (AIP) and Latchways (LTC). That observation still holds good. All three of those holdings have yet to produce decent performance; and the drop in Air Partner's share price since the autumn is particularly galling since it seems to have had no substance behind it (although we may well know more next week when the company announces final results for the year to end January). But none of the three has revealed weaknesses that did not figure in my investment assessments.

My main reservations continue to focus on the shortcomings in GlaxoSmithKline (GSK), Carillion (CLLN), Mitie (MTO) and Ladbrokes (LAD). I have dealt with all these at various times over the past few months, in particular Glaxo (see Bearbull, 19 September 2014), Mitie (16 January 2015) and Ladbrokes (2 January 2015). Glaxo is in a long-term decline that will undermine its ability to maintain its dividend within the next few years. The state of Mitie is hardly as serious, but it will never again be a growth stock and its shares - at 287p - look overpriced by maybe as much as 40 per cent.

As for Ladbrokes, somehow it can never do anything right. Late last year the bookmaker seemed to have turned the corner when, very belatedly, its digital operation - ie, online betting, especially via smartphones - came right. On top of that, City analysts got themselves worked up at the prospect of a sexy external appointment to replace Richard Glynn, the under-pressure chief executive. Their disappointment was palpable when Jim Mullen, an internal candidate, got the job last month. This may be very unfair on Mr Mullen, who has only been with Ladbrokes for 16 months anyway; he joined from William Hill (WMH) and has spent all his career working on IT-related business plans.

Clearly I have no idea whether Mr Mullen's appointment will be a good one, but neither - I reckon - do the City analysts. Still, the underwhelming response means the share price has lost all the gains it made earlier in the year and I am left wondering - for the umpteenth time - whether it's not best simply to get shot of the Ladbrokes holding. Answer - not while an 8.9p dividend for 2015 is still promised. Besides, the income is not to be scoffed at - after all, generating yield is what an income portfolio must be all about. The fund has a bit too much cash anyway and will get next to nothing from its Antofagasta holding. Making good those shortcomings is the top priority. After that there is the question of replacements for Glaxo, Carillion and Mitie. Surely that's enough to be getting on with.