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Finding opportunity amidst the roller coaster

of platinum shares

Investing in platinum shares over the last decade has been a roller coaster ride. Investors have experienced the euphoria of the highs, the fear and uncertainty of the declines, and twists and turns of the Platinum Group Metals (PGM) cycle along the way. Recently this ride has notably slowed, mirroring a downturn in demand which has been underscored by the approximate 40% drop in the rand PGM basket price compared to a year ago.

 

Platinum Group Metals (PGMs) are essential and precious metals which include platinum, palladium, rhodium, iridium, and ruthenium. These metals are known for their purity, high melting points and unique catalytic properties.

Recapping the cycle

The journey over the last decade should not be viewed in isolation but as part of what has become known as the commodity “super cycle.” A commodity super cycle is a period of sustained economic growth which is accompanied by continuous demand for commodities, resulting in rising commodity prices. This, in turn, triggers further investment in supply by producers who seek to benefit from the elevated commodity price levels. Since it takes a number of years for supply to enter the market, the prior years of constrained supply result in a prolonged period of high commodity prices.

 

The inverse applies for a period of excess supply in the market, which depresses prices until it is no longer viable for producers to sell their products at, or above, their marginal cost of production. At this point it becomes uneconomical to sustain production which becomes evident in tight margins; negative earnings; diminished cashflows; the possible suspension of dividends; deferment of growth plans and strained balance sheets. This in turn prompts producers to cut back on supply to curb loss-making production, leading to the bottoming of the cycle. A super cycle is primarily driven by rapid industrialisation and/or urbanisation of the global economy. Beginning in 1996, the last super cycle was driven by the industrialisation of the BRICS countries, particularly China which peaked in 2010, and was brought to a halt following the global financial crisis towards the end of that decade.

Changes since COVID

After years of low prices which translated into poor cashflows and years of underinvestment, platinum producers were helped by the supply disruptions which were caused by COVID-19, followed by the Russia-Ukraine war. The recovery in prices allowed for PGM producers to replenish their balance sheets and deploy, not only maintenance, but expansionary capital expenditure. The exorbitant increase in palladium and rhodium prices resulted in a structural shift in demand in both rhodium and palladium markets. Thrifting away from rhodium to platinum in the Chinese fibreglass industry, and an acceleration by car makers in substituting platinum (Pt) for palladium (Pd) in vehicle auto catalytic converters, have both occurred.

 

In the longer term, there is a major risk to PGM demand due to the growing electric vehicle penetration, with EVs (Electric Vehicles) using little to no palladium and rhodium. To some extent this is partially offset by the use of PGMs in hybrid vehicles which are growing market share in a recovering new vehicle market. The platinum market appears to be in a deficit, however, there is an estimated 4 million ounces of above-ground platinum stock. A recovery in demand for metals will be driven by the return of car manufacturers to market as inventories unwind.

 

In the current supply and demand environment, half of the PGM industry’s cost curve is not profitable at current spot prices of circa R25 000 per PGM ounce. However, price to book multiples (a measure of how much the market is willing to pay versus the book value of the company) and earnings of platinum producers have not yet reached the lows of the previous downcycles.  If spot prices hold for a prolonged period, it will become uneconomical to sustain production and withstand the downcycle. We are beginning to see the signs of a bottoming of the cycle through the recent actions taken by producers namely Sibanye, Impala, Anglo American Platinum, and to a lesser extent, Northam. These actions are aimed at cutting costs and include reducing controllable capital expenditure, preserving cash by deferring development plans, restructuring workforces through retrenchments, and beginning to place loss-making ounces under care and maintenance.

Learnings from the last PGM cycle

While the notion of commodity cycles tends to offer a familiar rhyme, each cycle produces some unique elements. We share our 4 key learnings from the past decade of the PGM cycle and demonstrate how we have applied the learnings in our PGM stock selection for the next cycle.

 

1. Cost curve positioning

A PGM cost curve ranks producers from lowest to highest cost producer, based on production volumes. Two years ago, when the PGM basket was reaching all-time highs of above R40 000 per PGM ounces, cost curve positioning did not matter. Even the highest cost producers with an average production cost of R35 000 per PGM ounces were in the money. Appropriate cost curve positioning meaningfully increases a producer’s ability to withstand the down cycle and be profitable through the cycle, and not just at points where PGM prices are elevated. This is what separates companies which manage to survive from those who shut down, and enables producers to grow regardless of which point in the cycle the market is.

 

2. Capturing the smaller cycles within the bigger cycle

The nature of the PGM cycle presents opportunities within the cycle to earn a repeated source of returns. With the benefit of hindsight, during the last decade there has been at least two good opportunities to invest in PGM shares. In 2015, the dollar PGM basket price fell 31% due to lower global growth, particularly in China, coupled with the vehicle emissions scandal (Dieselgate). The subsequent result of this led to a meaningful decline in the SA PGM stock prices making it an attractive entry point. The market overlooked the benefit of a depreciating currency which resulted in the rand basket price declining by 7% as depicted in figure 1. Tighter emission standards led to a greater preference for gasoline/petrol vehicles over diesel and greater use of palladium in a auto catalyst. As strong demand fundamentals oscillated between the 2 main PGM elements (Platinum and Palladium,) it became more important for investors to shift from a “pure platinum play” to a “PGM Basket play” as thrifting (the process of replacing rare or expensive metal with more effective, adaptable or accessible metal that fulfils the same use case) began to take place. Another opportunity arose in 2020 catalysed by the COVID-19 crisis, which was directly followed by the Russia-Ukraine war when the supply shock led to palladium and rhodium reaching multiple record highs in 2021-2022.

 

3. The fundamentals matter in the purchase decision  

We see the business fundamentals of a company as the guardrails that help not only hold on but see through the short term headwinds faced by an investment holding. The key drivers for a resource company are price, volume, and costs, coupled with a strong balance sheet to fund future projects. We look for opportunities where the market is pricing in PGM prices below the marginal cost of production (90th percentile), volumes are stable or growing, there is visible normalisation of costs, and low gearing levels. When the above conditions are present and the market overly penalises the share during a downturn, this give investors like ourselves sufficient margin of safety and confidence to withstand the temporary downturns.

 

4. Stock picking is key 

The SA PGM market consists of large, listed players Anglo American Platinum (AMS), Impala Platinum (IMP), Northam Platinum Holdings (NPH) and Sibanye Stillwater (SSW). On a 10 year view, the top performers with an annualised growth rate of 13.2% and 9.4% were NPH and AMS and the laggards at 6.7% and 1.4% were SSW and IMP. There were clear winners and losers. This clearly indicates that stock picking was key and it is not enough to get the sector call right. A stock picking example is our investment in Royal Bafokeng Holdings (RBP) as depicted in figure 2. For many years leading up to 2021, the market did not recognise the growth in production after a decade of investment and as a result did not attribute value. The thesis was premised on unrecognised growth which was later recognised by Impala that was in need of production growth allowing us to crystalize the value through Implats’ offer price of R150 for RBP, enabling Perpetua’s clients’ portfolios to benefit from this trade.

Figure 1: PGM basket in USD vs ZAR over 10 years

Source: Bloomberg

Figure 2: RBP holding over time

Source: Perpetua research

The application of the investment case

The last decade of the PGM cycle has enabled us to enhance our framework around PGM investing.  

This framework focuses on:

  1. Understanding the supply/demand drivers of the PGM’s as this will influence commodity prices.
  2. Cost curving positioning, a key competitive advantage.
  3. Prudent management team with a clear strategy to prioritize value or volume with a capital allocation framework that is aligned with shareholders’ interest.
  4. A balance sheet to withstand the cycle.
  5. Buy at a discount (risk/reward) to through-the-cycle earnings.

Our current top pick is Northam Platinum which we believe meets our investment criteria, with roughly 60% exposure to platinum, a growing volume outlook and first quartile position on the cost curve (meaning that it’s a relatively low-cost producer). Going forward, more than 50% of NPH’s production profile will come from the best competitively positioned mine in the industry, Booysendal.

 

In the past we had been concerned about its previously high debt levels and capital allocation framework.  However, after the sale of its in RBP stake, the business has degeared to 0.24x net debt to EBITDA (Earnings Before Interest Tax Depreciation and Amortisation) and has access to R22billion of available liquidity. Furthermore, there is a realignment of capital allocation priorities with a greater internal focus on the growth plan of existing operations. Notwithstanding the above improvements within the business, the market is implying that the current below normal PGM price environment is permanent which we believe is an overly pessimistic assumption in the longer term. In our view, it is unsustainable for the industry to operate at these price levels for very long, without a meaningful supply reaction (contraction). In our fundamental analysis, as is our approach for cyclical companies, we have done extensive scenario assessments and stress tests, and continue to assess the extent to which Northam can withstand a protracted downcycle. Given our entry price and the confidence our analysis has provided, together with the learnings that have come from previous cycles, we believe our client portfolios are well positioned to take advantage of the current investment opportunity we see in Northam Platinum.