Baker Steel Resources Trust — Several potential NAV triggers ahead

BSRT is a closed-ended investment company registered in Guernsey and listed on the London Stock Exchange since 28 April 2010. It aims to achieve long-term capital growth through investing in equity, loans and related instruments issued by natural resources companies, targeting a global concentrated portfolio of 15–20 investments. BSRT’s objective is to realize attractive investment returns through valuation gains resulting from development progression of investee companies’ projects and through exploiting market inefficiencies and pricing anomalies.

BSRT focuses primarily on investing in unlisted companies which, despite strong fundaments and attractive growth prospects, are undervalued in the manager’s opinion. For the purposes of the investment policy, natural resources companies are defined as those involved in the exploration and production of base metals, precious metals, bulk commodities, thermal and metallurgical coals, industrial minerals, oil & gas and uranium. These may be single asset as well as diversified natural resources companies. BSRT focuses mainly on investing in companies with producing and/or tangible assets, which typically comprise resources and reserves verified under internationally recognised reporting standards, such as those of the Australasian Joint Ore Reserves Committee (JORC). BSRT may also invest in exploration companies whose activities are speculative by nature.

The company aims to realize unlisted investments through an IPO, trade sale, management repurchase or other methods. While unlisted companies are its priority, it also holds listed securities – typically special situations and less liquid securities.

BSRT’s investment manager is Baker Steel Capital Managers, a specialist natural resources asset management and advisory firm, headquartered in London, with a branch office in Sydney, Australia. The firm has an experienced team of fund managers covering precious metals, base metals and minerals sectors worldwide, including equity markets and underlying commodity markets. Investment opportunities are mainly sourced from the investment and advisory team’s extensive proprietary network of industry contacts. Baker Steel’s managing partner Trevor Steel has acted as lead manager since its launch. He is supported by Francis Johnstone, with David Baker and Mark Burridge also sitting on BSRT’s investment committee.

In the natural resources sector, 2019 was marked by substantial disparities in performance across the mining subsectors, as the precious metals segment shone but the broader commodity markets faced mixed fortunes.

The bull market for precious metals remains intact, with gold and silver prices up by c 19% and 16% in 2019, respectively. In this favourable environment, gold equities (represented by the EMIX Global Mining Gold Index) posted an annual return of 42.4% against 22.7% returns on the MSCI World Metals and Mining Index, with an active investment approach improving returns to 51.9% (illustrated by the BAKERSTEEL Precious Metals Fund). The manager believes that in the coming year, precious metals equity prices will be assisted by the improving profitability of producers on the back of higher gold prices amid low real interest rates, expanding debt levels and the currency war. Furthermore, as risk in the financial markets increases, demand for gold and associated portfolio diversification rises accordingly. Potential further geopolitical tensions are likely to affect the currency markets (including the US dollar) in 2020, which reinforces the role of gold as a safe haven for investors and further improves the outlook for BSRT’s largest exposures.

Importantly, BSRT sees the most substantial opportunity in the precious metals sector in recovery at the initial stage. In addition to a supportive macroeconomic environment, several companies have driven operational efficiencies proactively, which should prove supportive to their market valuation. These include management reforms and revisions to capital discipline and cost control, as well as constructive M&A activity. Recent high-profile transactions proved beneficial rather than value-destructive for investors, including Northern Star and Saracen acquiring Barrick and Newmont’s Kalgoorlie operations, Kirkland Lake’s proposal to buy Detour Gold and Evolution Mining acquiring the Red Lake gold complex from Newmont Goldcorp. Growing dividends represent an additional value driver.

Performance in the speciality metals market varied across subsectors in 2019, as some strategic metals experienced supply tightness, while others faced demand weakness and/or destocking. Although palladium and nickel provided the highest returns in 2019 (53.6% and 31.2% respectively), the market offers limited opportunities to benefit from them. However, the long-term outlook for underperforming speciality metals appears much brighter, with huge potential new demand for speciality metals from the development of new technologies (EVs, batteries and green technologies).

The overall top performing metals during 2019 included palladium (53.6% annual return), which benefited from continued strong fundamentals amid the shift away from diesel cars, and nickel (31.2%), which saw significant price gains in Q3 due to record-low inventories and concerns over restricted supply from Indonesia. As both metals are used in the production of traditional and electric vehicles, the outlook for the next few years remains positive, according to the managers, bearing in mind the potential to substitute platinum for palladium. Platinum appears oversold, but lacks demand drivers.

At the other end of the performance spectrum, vanadium and lithium exhibited weak performance, with the former impaired by niobium substitution and high levels of by-product volumes in China, and weaker than expected demand for the latter amid Chinese EV subsidy cuts. Having said that, expanding EV sales in Europe should drive positive lithium performance in 2020. The development of the EV market remains a core long-term driver for many speciality metals, as its share in annual global light vehicles sales is expected to exceed 10% by 2024, and accelerate to reach 55% by 2039 (source: BloombergNEF data).

Subdued investor sentiment and concerns over economic growth put pressure on the industrial commodities market in 2019, which is struggling to recover from the lows of the past few years. However, the outlook is improving amid low inventories following declines in recent years, indicating tighter supply. Potential brightening of the broader macroeconomic outlook could serve as a near-term catalyst, while longer term the metals stand to benefit substantially from the electrification of transport and the transition towards clean energy.

As illustrated in Exhibit 4, mining equities suffered from the bear market until the end of 2015, losing almost half their value in the last 12 months. However, this was followed by an equally strong rebound, which allowed the EMIX Global Mining Index to make up lost ground the next year. Since then the index performance has developed broadly in line with the MSCI AC World Index, while outperforming the UK All Companies Index. The annualised five-year performance of the EMIX Global Mining Index stood at 10.1% vs 12.0% and 6.3% for the above comparators, respectively. Recently, broad market indices to some extent caught up with the EMIX Global Mining Index, as they posted double-digit returns against the 9.0% recorded by EMIX in the 12 months ending 31 January 2020.

Despite the recent robust performance, mining equity valuations are still in the recovery phase as the forward P/E multiple at end-February 2020 remained below its 10-year average value. Consequently, dividends payouts in the segment look more attractive, with a dividend yield of 5.7% vs the 10-year average of 3.6%.

Rather than gearing exposure to benefit from anticipated commodity price rises, the manager focuses on riding the project development curve to generate valuation gains. The three primary sources of return for BSRT’s portfolio investments (see Exhibit 6) are as follows:

Following its launch in 2010, BSRT mainly invested in companies with projects that were around the bankable feasibility stage, whereas more recently, the focus shifted towards companies that are relatively close to moving into production (eg Tungsten West, Cemos Group and Futura Resources), due to better value opportunities (according to BSRT).

Prior to investment, the management team identifies c 1,000 potential investments, with c 100 being subject to a detailed review, with the aim of completing three to four investment transactions per year. The investment process can take more than a year from initial discussion to successful conclusion of a trade, with a typical investment horizon of three to five years. Management notes that any investment opportunity will not be pursued if the desired terms cannot be agreed. That said, we note that BSRT usually has strong bargaining power, as it typically invests alongside an investee company’s management team, rather than larger institutional shareholders or local governments.

While capital growth driven by equity exposure remains the manager’s key objective, he also looks to secure downside protection for BSRT’s investment, typically investing via convertible loan notes, and often in stages as development milestones are met. The manager is also often able to structure BSRT’s investment such that the financial terms are improved if project development objectives are not met within a specified timeframe, which acts as an incentive to investee company management, as well as providing further downside protection.

BSRT’s investment policy allows holding a wide range of investments in addition to unlisted and listed equities and equity-related securities, including but not limited to commodities, convertible bonds, debt securities, royalties, options, warrants and futures. In order to manage and hedge the portfolio efficiently, derivatives may also be used, but normally currency exposures will not be hedged. BSRT may also seek exposure to other companies within the wider resources and materials sector, including services companies, transport and infrastructure companies, utilities and downstream processing companies. There are no fixed limits on allocation between unlisted and listed equities or equity-related securities and cash, but the manager aims to adhere to the broad allocation criteria described in our initiation report.

BSRT typically holds a concentrated portfolio of 15–20 investments, with the top 10 holdings representing c 84% of NAV and a minor net cash position of c 1% of NAV at 31 January 2020. Although concentrated, the portfolio is diversified by commodity and geography (in terms of project location), with the largest exposure to the precious metals sector mainly through Bilboes Gold, Polar Acquisition and Polymetal (c 34% of NAV, see Exhibit 7). Coking coal, represented by Futura Resources, and cement & oil shale produced by Cemos Group complete the top three with 15% and 10% share, respectively. Geographic exposure covers a range of developed and emerging economies with the largest projects located in Russia (18% of NAV), Zimbabwe (16%), Australia (15%), and Morocco (10%).

Recently, the manager has mostly invested through convertible debt instruments or royalties, which we understand (based on our conversation with the company) represented c 37% and c 18% of BSRT’s portfolio at end-December 2019 respectively, with 32% held as unlisted equity and c 12% as listed equity. BSRT currently holds four listed investments: LSE-listed Polymetal International and Metals Explorations, as well as Ivanhoe Mines and Azarga Metals listed on the Toronto Stock Exchange, with the value of these holdings updated in the monthly statements in line with the latest market price. In the last 12 months, BSRT has significantly reduced its position in Polymetal International, as it fits the strategy of early-stage investments having been received as consideration for the sale of Polar Silver, and reinvested the proceeds into developing enterprises.

As we described BSRT’s key holdings in detail in our initiation report, we now focus on the more recent investments concluded in FY19, which include Mines & Metals Trading (MMTP, Peru) and Tungsten West. The former is a private company incorporated in the Isle of Man, which owns the Recuperada project in Peru, comprising c 11k ha of mining concessions for silver, lead and zinc, centred around a 600 tonnes per day processing plant. In H119, MMTP began processing ore from its own concessions, rather than from third-party miners. BSRT opted for investment in the form of a US$4m subscription in a convertible debenture, with an interest rate of 10% pa, repayable within three years and convertible at the company’s option into 20% of MMTP shares. In January 2019, MMTP signed a letter of intent for a reverse takeover of Zincore Metals, whereby Zincore will acquire all of MMTP’s issued and outstanding securities, and MMTP shareholders will hold 95% of the enlarged group. The definitive business combination agreement was announced on 24 December 2019. Once the transaction is concluded (expected in March 2020), a new entity, Latitude Base Metals, will be formed and listed on the TSX Venture Exchange.

On 29 November 2019, BSRT used funds from the partial sale of its stake in Polymetal International to invest £5m in secured convertible loan notes in Tungsten West, which operates the Hemerdon Tungsten Mine, acquired from the official receiver for Wolf Minerals. Wolf had operated Hemerdon since 2015, but never achieved the targeted tungsten recovery level, facing issues with recovery. Following extensive mineralogical and metallurgical test work, Tungsten West decided to acquire the mine and operate it with a different approach, focused on sorting ore before processing and using magnetic separation methods. Tungsten West believes this will allow it to resolve the problems faced by the previous owner.

As BSRT is not using an official performance benchmark, we use EMIX Global Mining index to provide a useful broad reference for comparison. The annual NAV return of c 30%, recorded in FY19, was ahead of the EMIX Global Mining index posting a 23% return, which follows the significant outperformance in the preceding period. Consequently, the annualised BSRT NAV total return for the three-year period stood at 15.6% against 11.8% recorded by the index. The fund also successfully outperformed broad market indices such as MSCI AC World and UK All Companies Index, for which annualised returns for the same period remain in single-digit range. In January 2020 (latest available data), BSRT posted a minor monthly negative return of 0.8%.

In Exhibit 10, we also present returns relative to the UK All Companies Index and MSCI AC World indices for wider context.

Comparing BSRT’s share price and NAV performance against key indices over time horizons ranging from one month to almost 10 years (inception date 28 April 2010) reveals the lack of significant relation between them. Since its launch in April 2010, BSRT has seen extended periods of both underperformance and outperformance, which might have been expected given the varying nature of BSRT’s largely unlisted investments and their private equity-style return profile. The fund is not managed against any benchmark, but rather as a threshold for paying a performance fee. However, comparing performance against relevant indices provides some context.

BSRT performs a comprehensive review and revaluation of its portfolio twice a year (at the half year and full year results) based on the following methodology:

Apart from interim and end-year revaluations, BSRT also updates its portfolio value on a monthly basis for the price movements of listed equity investments, and the valuations of unlisted equities in the case of relevant new transactions. It is also worth noting that BSRT does not hedge its currency exposure, therefore monthly valuations fluctuate in line with FX changes.

In Exhibit 12, we present BSRT’s selected key NAV triggers over the last 12 months. These include in particular Bilboes Gold and Polar Acquisition projects, as well as holdings in Polymetal International. As BSRT was in the process of selling its stake in Polymetal during the period (it initially represented 29% of NAV at end-December 2018), the figure presented in the table below merely represents the overall total return on the company’s shares and does not correspond to the return generated by BSRT during the period.

BSRT entered FY20 with a positive view on the near-term outlook for its portfolio, as it sees multiple further NAV catalysts (see below).

After rebounding from the local trough in 2015/16, BSRT’s discount to NAV currently sits at 30.9%, which is however below the three-year average of c 21.1%. Over the last 12 months, the discount to NAV remained within a range of c 15–25% for most of the time, but has recently widened amid the broader market sell-off.

Following a tender offer for c 9.7m own shares in May 2019 and their subsequent cancelation, BSRT now has 106.5m ordinary shares and c 9k ordinary shares in issue held by management, of which 700k (ordinary shares only) are held in treasury. BSRT has the authority, renewed annually at the AGM, to make market purchases up to 14.99% and to allot up to 10% of its ordinary shares in issue. The ordinary shares held by management are held by BSRT’s investment manager, Baker Steel Capital Managers (5.5% of BSRT’s shares in issue as at 10 February 2020).

BSRT is permitted to borrow up to 10% of NAV to meet short-term cash flow requirements, but does not currently have any debt or borrowing facilities in place, and continues to hold sufficient cash and listed investments to enable it to meet its obligations as they arise. At end January 2020, BSRT’s net cash and equivalents amounted to 0.9% of NAV, while its holding in Polymetal International accounted for a further 6.6% of NAV, against 1.5% and 29.1% respectively as at end-January 2019.

Baker Steel Capital Managers is paid a monthly management fee of 1.75% pa on BSRT’s average market cap. The manager is also entitled to a performance fee of 15% of the total increase in NAV in each financial year above an 8.0% pa compound hurdle since inception, relative to the highest previously recorded NAV for which a performance fee has been paid (ie subject to the high water mark). The performance fee only becomes payable following sufficient net realised gains. However, no performance fee has been earned since FY11. BSRT paid management fees of £464k in H119 (£483k in H118) and incurred total expenses of £724k in the period (£716k in H118). As at end June 2019, LTM ongoing charges amounted to £1,415k, which translates into an ongoing charges ratio of c 2.0% of NAV. Management fees and expenses are charged 100% to the revenue account.

Based on its capital returns policy introduced in 2015, BSRT will distribute no less than 15% of aggregate net realised cash gains (net of losses) in each financial year, calculated following the publication of audited financial statements. These distributions may be made in the form of share buybacks, tender offers or dividend payments, at the board’s discretion. To date, no dividend payment has been made, but the company executed share buybacks, with the latest concluded in FY19. In May 2019, following AGM approval, BSRT launched a tender offer to buy back around 8% of its share capital (9.7m shares) at a fixed price of 51p per share. The price represented a c 11% premium to market price and c 10% discount to the unaudited NAV as at end April 2019.

In addition to the capital returns policy, the board hopes that over time, income received from royalties, interest on convertible loans and future dividends received from investee companies will support a regular dividend or liquidity event by BSRT. The manager notes that BSRT holds royalty agreements with Polymetal and Futura Resources on assets that are not yet producing, and has an option to acquire a royalty on Azarga Metals’ Unkur project, so income is expected to become a meaningful contributor to returns over the medium term.

BSRT’s peer group consists of investment companies focused on commodities and natural resources, with a market cap above £10m. Their strategies include investment in both early-stage enterprises and mature businesses. They differ in terms of natural resources market subsectors, as well as the preferred form of investment instruments.

Exhibit 15 compares BSRT with a peer group of trusts with similar characteristics. As the investment strategies of the selected funds vary widely, the performance outcome in each analysed period falls within an equally broad range, exemplified by three-year NAV total returns of -51.1% to +54.3%.

In each of the analysed time horizons, BSRT’s NAV total return ranks among the top performers, with the second highest value over one year, and the highest in the three- and five-year investment periods. Although BSRT’s latest share price discount to NAV ranks in the middle of the group, it is slightly narrower than the peer average (30.9% vs 37.3%). Its ongoing charge ratio is in line with the peer average, but it is worth noting that BSRT also charges a performance fee. BSRT is one of three peer group funds that do not employ gearing, and one of five funds that do not currently pay dividends.

BSRT’s board comprises four non-executive and independent directors, three of whom are have served on the board since BSRT’s incorporation in March 2010. No limit is imposed on the length of service of any director, but the board has put a succession plan in place to refresh its membership while maintaining a degree of continuity, following corporate governance best practice. As part of this process, Chris Sherwell retired at the May 2019 AGM, having served as a director for over nine years, and was replaced by David Staples (appointed 29 May 2019). All directors stand for re-election annually at the AGM, and there is also a shareholder vote on maximum aggregate board remuneration. The current cap is £200,000 per annum, and total board remuneration was £57,000 for H119 and £115,000 for FY18.

Chairman Howard Myles was a partner at Ernst & Young from 2001 to 2007, responsible for the investment funds corporate advisory team, and previously spent 14 years at UBS Warburg. Myles has served on the boards of a number of investment trusts and is currently chairman of JPMorgan Brazil Investment Trust, and a director of Chelverton UK Dividend Trust and The Forest Company.

Charles Hansard has over 31 years' experience in the investment industry, formerly serving as a director of Apex Silver Mines and as chairman of African Platinum. He currently serves on a number of boards, including the Moore Capital group of funds and Electrum, a privately owned gold exploration company.

Clive Newall has worked in mining and exploration throughout his career, having held senior management positions with Amax Exploration and the Robertson Group, and has been a director of a number of public companies in the UK and Canada. He is the founder of First Quantum Minerals, and has been its president and a director since its incorporation.

David Staples worked for PwC for 25 years, including 13 years as partner. He has many years' experience serving on the boards of listed and private companies as a non-executive director, including as chairman of listed investment companies. Mr Staples has a BSc in Economics and Accounting, is a chartered accountant, a chartered tax adviser and a member of the Institute of Directors.