I have been really enjoying Margaret Moran’s "Behind the Numbers"series, especially liked her recent article on Greenblatt's Earnings Yield and Return on Capital. Joel Greenblatt (Trades, Portfolio) is an investor I admire immensely. His book "You Can Be A Stock Market Genius" is one of my favourites of all time.
Though Greenblatt's earnings yield and return on capital, which together make up his "Magic Formula," are typically applied to U.S. stocks in backtesting studies, these metrics can also be useful for non-U.S. stocks. Thus, I decided to run this screen on the UK market, putting in a minimum market cap of 1 billion British pounds ($1.39 billion) and excluding the utility and finance sectors. I also restricted the search to ordinary shares (common stock) and excluded secondary listings.
The results were very interesting. Giving equal weighting to the rankings of earnings yield (which is the inverse of the price-earnings ratio) and return on total capital, the top five stocks were all metals and mining companies:
- Ferrexpo (LSE:FXPO, Financial): The earnings yield is 30%, while the return on total capital is 43%
- Polymetal International (LSE:POLY, Financial): The earnings yield is 11%, while the return on total capital is 41%
- Evraz (LSE:EVR, Financial): The earnings yield is 10%, while the return on total capital is 27%
- Rio Tinto (LSE:RIO, Financial) (RIO, Financial): The earnings yield is 9%, while the return on total capital is 29%
- Centamin (LSE:CEY, Financial) (TSX:CEE, Financial): The earnings yield is 9%, while the return on total capital is 26%
We had one more metals and mining company in the top 10: BHP Group (LSE:BHP), which ranked eight overall, with an earnings yield of 8% and a return on total capital of 20%. This confirms my hunch that mining stocks are looking cheap following about a 10% fall for the sector over the last two months.
Thoughts on the top five stocks
Ferrexpo (LSE:FXPO, Financial) from Ukraine engages in the mining, processing and selling of iron ore pellets to the steel industry and has been engaged in corporate governance-related troubles over the last few years. Its stock is up 165% over the last 52 weeks, yet it still trades on an enterprise value to Ebitda ratio of just 3.9. The stock is cheap, and we see value investor GMO (which also recently made a good case for resource equities as an inflation hedge) and quantitative value investor Dimensional Fund Advisors in the list of top 10 shareholders. It appears in the argument between “commodity supercycle” and “demand normalisation.” The stock market isn’t buying the supercycle theory. With former CEO Kostyantin Zhevago fighting allegations of embezzlement, it might be that Ferrexpo is suffering from temporarily negative market sentiment. Analyst consensus estimates have this stock on a “hold” rating, which is as good as a sell rating. The stock carries some political risk, and iron ore is a China-dominated market, but this stock is, as the saying goes, cheap as chips.
Operating in Russia and Kazakhstan, gold and silver miner Polymetal International (LSE:POLY, Financial) is an interesting company. It is one of the very few gold-mining companies with “pressure oxidation” processing. This is important because high-grade refractory gold reserves offer the potential for lower costs per ounce but refractory ore requires more sophisticated treatment methods through pressure oxidation. In short, this gives Polymetal a cost advantage and the potential to get better access to gold reserves in a world where reserve grades are going down and new mines have been in short supply. This means over the longer term Polymetal should be to grow its production, which is a key metric vs. gold peers, as all gold miners are essentially exposed to the same gold price. Polymetal’s margins are also high relative to other gold miners globally. The stock’s cheapness may be related to the loss of appetite in gold more generally, given gold prices are down around 10% over the last year. This is certainly a stock on my watchlist, and I will revisit it soon. Jeremy Grantham (Trades, Portfolio)’s GMO is among the top 15 shareholders.
Russian oligarch Roman Abramovich owns 29% of Evraz (LSE:EVR, Financial), which engages in the production and distribution of steel, vanadium and coal products. The company is trying to demerge its coal business, and shareholders have recently revolted due to a lack of diversity at the company. At the recent AGM, a number of directors had high percentages of shareholders vote against their re-election. It appears that Evraz is not an ESG darling, and this is playing on its share price. Analysts consensus gives it a a “hold,” which, given the tendency for brokers to be bullish on nearly all stocks, definitely gets my contrarian antennas picking up.
Rio Tinto (LSE:RIO, Financial) (RIO, Financial) has also had recent governance issues, although one wonders how fundamental they would be given Rio’s dominance in the world's iron ore markets. Rio has long been a solid dividend stock thanks to its fortress balance sheet and market leading iron ore margins. Rio’s exposure to copper also makes it attractive in the whole energy transition megatrend, which I intend to revisit. Rio’s financial strength is demonstrated with a strong Altman Z-score of 3.2 and a perfect Piotroski F-score of 9. This is another stock high on my watch list. Baillie Gifford (Trades, Portfolio) is a top 20 shareholder with large holdings via its International Alpha Fund and Global Alpha Equities Fund.
Centamin (LSE:CEY, Financial) (TSX:CEE, Financial) engages in the exploration, development and mining of precious metals. Its Sukari gold mine in Egypt is its one producing asset. It also is conducting exploration in West Africa and has resources in Burkina Faso and Cote d'Ivoire. It has an Altman Z-score of 13.4 and a near perfect Piotroski F-score of 8. Its dividend yield of 6.3% is a true differentiator from industry peers and a hallmark of Centamin’s investment case. With capital expenditure decreasing and production increasing from 2021 onwards, the free cash flow profile is very supportive for coverage of a robust dividend yield. Famed quantitative value fund Dimensional Fund Advisors owns nearly 5% of the company. Centamin has very good growth potential too. At the recent results of the company's review of its West African exploration portfolio, CEO Martin Horgan said:
"Building a strong active growth pipeline is central to our strategy, while maintaining our capital allocation discipline. Today's announcement of a positive preliminary economic study at Doropo and the exploration potential at the earlier stage ABC [project], demonstrate the quality and potential of our portfolio.
The Batie West Project has potential to deliver a profitable mine, but not one that would currently meet our strict investment criteria. We are now initiating a review of development options for this asset.
The Doropo Project is very exciting and is our priority growth target outside of Egypt, showing excellent potential to become Centamin's second mine. Our highly experienced team has proven expertise at delivering successful gold projects in West Africa and will now commence the PFS [pre-feasibility study], the results of which we look forward to announcing in mid-2022."
I own Centamin for the dividend, the pure play gold exposure and the exploration and development optionality.
