The Basic Materials industry is represented by industrial metals and forestry/paper stocks, yet the dominant component by a long mile is mining. Although we’re presently in the wrong part of the commodities cycle for any company to stand a chance of overtaking the large cap behemoths including Glencore (GLEN) and Rio Tinto (RIO), anyone who takes a long-term positive view on commodities does have a chance of buying a good selection of small and mid cap stocks that have great assets that could, in time, generate significant value for shareholders.

Investors seeking to back tomorrow’s big miner should focus their attention on the mid-cap space, being the £200 million to £2.5 billion market cap range. At the top end is precious metal producer Polymetal International (POLY) which has assets in Russia and Kazakhstan. The cash generative group has numerous development projects, in addition to producing mines, but progress has been slowed by low gold and silver prices.

Petra Diamonds (PDL) has built up a large portfolio of mines in South Africa and Tanzania where near-term development work should eventually result in significant cash flow.

Egypt-based Centamin (CEY) is battling geopolitical issues but assuming it can resolve licence issues then the gold producer is best placed for a major re-rating in the sector, given a top-quality asset and steps to try and diversify into new geographical territories.

Asset quality is also a major theme at Gem Diamonds (GEMD) whose Letseng mine in Lesotho has produced countless top-notch stones. A second mine, Ghaghoo in Botswana, is in the final stages of development and should start bonefide production later this year.

Although Kazakhmys (KAZ) has undergone a period of asset sales, the Kazakh copper producer is laying the foundations for a return to growth, having bought the large-scale, low-cost Koksay copper asset earlier this year.

The table on page 36 shows the five fastest growing Basic Materials companies by revenue. Investors mustn’t presume these are the companies set to challenge the big players. While the data is very interesting in itself, showing the potential rate of growth that is possible from the sector, it is slightly misleading in that several of the companies are growing from a low base.

Botswana-based metals producer African Copper (ACU:AIM) was on the verge of going bust when the global credit crunch hit. It was then subject to a bid war. A 101.5% compound annual revenue growth over the past five years is not a reason to get excited and make an investment. Its mine has been a stop/start operation for a long time due to financial and operational issues, so it most certainly has revenue growth coming from next to nothing. The business is almost entirely owned by Chinese group ZCI when you include equity and debt and you could argue this is the biggest share overhang on all of AIM. The investor wants shot of its holdings and has so far failed to find a suitable buyer. We understand ZCI’s latest strategy is to wait for the mine to start running properly and then try once again to exit.

South America-focused Hochschild Mining (HOC) had the hallmarks of a challenger company until the silver and gold price correction in 2012. That’s forced the company to make cut backs, reduce greenfield exploration and saw the dividend suspended. Yet if you look at its growth pipeline, there’s no reason that Hochschild couldn’t make another stab at challenging the big gold players if precious metal prices can increase once again in value.

Hochschild needs a higher silver and gold price to help repair the bottom line as it is presently forecast to be loss making once again this year. But the top line will be helped by bringing a new mine (Inmaculada) on stream in the fourth quarter of 2014. Another mine, Crespo, should follow in 2017 by which point the company should be producing 34.7 million ounces of silver equivalent versus 20.5 million ounces in 2013. Such growth would be impressive, but most analysts say now is not the time to buy the shares due to concerns about negative free cash flow.

African Barrick Gold (ABG) was spun out of Barrick Gold (ABX:NYSE) in 2010 with the intention of becoming a pure Africa-focused metals house, using its position in Tanzania as a platform for growing across multiple countries in the continent. That hasn’t gone to plan with the parent company selling down its holding and the child struggling with existing operations while also failing to expand geographically.

A management change and significant cost cutting has helped the business find its feet again with rising production and ongoing cost discipline helping the business return to cash generation. Theoretically now should be a good time to reappraise the company, but we need to see several periods of positive cash generation to really turn bullish. Prior to the second quarter results (25 Jul), operating cash flows were less than investing cash flows for nine consecutive quarters. We are also mindful that Barrick Gold still has more stock to sell. One to watch but not yet one to own.

(Click on table to enlarge)

Six years ago a constituent of the FTSE 100 and now valued three times less at £822 million, Ukrainian iron ore producer Ferrexpo (FXPO) is an example of a potential challenger company temporarily defeated by the global financial crisis which made it harder for miners to get large amounts of money to fund big growth projects. In 2008 Ferrexpo was producing 9.1 million tonnes of iron pellets. It had plans to quadruple output by 2018 by developing two projects on its licence area costing $6 billion. By 2009, growth projects were deferred. One of the projects is now in production but iron ore prices have sharply come off in price and the market looks over-supplied for a long time. The investment case is also soured by political problems in Ukraine.

The fallen idol

The unpredictable nature of commodity prices means that the mining sector can go from boom to bust in a short period of time. Indeed, six to eight years ago the list of potential challenger companies may have easily included Aquarius Platinum (AQP), mineral sands group Kenmare (KMR), nickel producer Talvivaara (TALV) and coal miner New World Resources (NWR) - all once FTSE 250 constituents but now in most cases struggling to stay afloat.

The majority of junior resource stocks on the market today simply talk about building projects that will become small but profitable mines. They aren’t seeking to dominate the metals or energy space; they are merely trying to survive until the next commodities price boom.

Anyone marketing their story on the premise of building up the next big mining house is unlikely to get a favourable reception. The market has turned its back on ‘growth at any price’ in the mining sector and would prefer slow but steady gains, and most certainly highly economical projects. At the top end of the spectrum, the large caps are streamlining by selling non-core assets and focusing on organic growth. It will take time for the industry to return to its ambitious growth phase but you can be guaranteed that it will happen and miners will have forgotten the lesson of the past decade that excessive growth can be bad.

Centamin (CEY) 63.8p

Market value: £739 million

Five-year compound annual revenue growth: 180.5%

Sector: Mining

The £739 million cap is battling geopolitical issues but assuming it can resolve licence problems then the gold producer is best placed for a major re-rating in the sector, given a top-quality asset and steps to try and diversify into new geographical territories including Eithiopia.

Centamin (CEY) earlier this month (14 Aug) declared its maiden dividend as it completes the next phase of expansion at its flagship mine, Sukari, which is expect to produce 420,000 ounces of gold this year.

The project is very big and could continue to stay this way even as ounces are depleted as there’s significant exploration potential. To be seen by investors as a true sector challenger, it needs to remove legal distractions.

Centamin has been fighting a court case since October 2012 brought by Hamdy El Fakharany, a lawyer and former member of parliament who has had previous success with similar asset ownership challenges in the property space. He has challenged the Egyptian government over the way in which the original licences were awarded for Sukari. A resolution to the legal issue could come in early 2015.

Gem Diamonds (GEMD) 217p

Market value: £305.6 million

Five-year compound annual revenue growth: -8.7%

Sector: Mining

Since floating in 2007, Gem Diamonds (GEMD) has bought a series of mines in an attempt to become the next big player. Some projects have since been dropped but its flagship asset, Letseng mine in Lesotho, is best in class for the diamond industry having produced countless top-notch stones.

A second mine, Ghaghoo in Botswana, is in the final stages of development. Between those two projects, Gem now looks to be in a strong position to restart plans to be a ‘challenger’ player. Ghaghoo’s got expansion potential which gives it a nice organic growth angle. Chief executive officer Clifford Elphick implies there’s merit in sector consolidation, particularly with companies owning neighbouring assets.

Explicitly that means Lucara Diamond (LUC:TSX), with whom it has previously held talks but which collapsed due to disagreement on valuation, Petra Diamonds (PDL) and Firestone Diamonds (FDI:AIM). Elphick says he knows to which of these three he’d like Gem to be wed but refuses to disclose the name. A marriage would be predicated on synergies from shared processing and having one not two management teams for the portfolio of mines.

Kazakhmys (KAZ) 301.4p

Market value: £1.4 billion

Five-year compound annual revenue growth: -3.5%

Sector: Mining

The Kazakhstan-based copper producer has undergone a period of change by selling its 26% stake in former FTSE 100 constituent Eurasian Natural Resources and declared plans to increase future production through three major growth projects. A name change to KAZ Minerals is imminent, representing a new era and the chance to regain the market’s favour.

Kazakhmys (KAZ) is selling most of the company’s high-cost, marginal, legacy asset base subject to regulatory approval and has bought a large-scale, low-cost copper project called Koksay which shows potential for 80,000 tonnes per year of copper and 60,000 ounces per year of gold.

The two existing development projects in its portfolio should start production next year, being Bozshakol and Aktogay. They should increase group annual copper production by more than 200,000 tonnes by 2016. This year Kazakhmys is expected to produce up to 85,000 tonnes of copper cathode, 120,000 tonnes of zinc, 3.7 million ounces of silver and 42,000 ounces of gold.

There’s no dividend at present and investors should note that any delay to starting up Bozshakol and Aktogay could strain the liquidity of the company on its current debt repayment schedule.

Petra Diamonds(PDL) 190.3p

Market value: £968 million

Five-year compound annual revenue growth: 46.8%

Sector: Mining

Diamonds have been one of the few commodities to enjoy strong pricing over the past few years, hence why Petra Diamonds (PDL) has caught investors’ attention. The market fundamentals are highly attractive given an absence of big mine discoveries for many years which will soon result in global supply constraints, despite the likes of Petra and Gem Diamonds expanding operations. That bodes well for further diamond price strength.

Petra has four mines in South Africa and one in Tanzania. It continues to find valuable stones, including a 122.5 carat blue diamond at the Cullinan mine which RBC Capital reckons could be worth $20 million and which is expected to be sold later this year. All of its mines are undergoing expansion which should result in Petra producing five million carats per year by 2019 - versus 3.2 million targeted for the year to June 2015.

That, in turn, should result in a rapid increase in free cash flow, moving from $13 million forecast in the financial year ending June 2015 to $161 million two years later. Costs aren’t expect to rise too much as it expands production thanks to increased used of mechanised mining which reduces manual labour dependency. Dividends are expected from 2016.

Polymetal International (POLY) 540.5p

Market value: £2 billion

Five-year compound annual revenue growth: 20.5%

Sector: Mining

The £2 billion cap has precious metal assets in Russia and Kazakhstan. The cash generative group has numerous development projects, in addition to lots of producing mines, but progress has been slowed by low gold and silver prices.

If the value of these shiny metals does improve, Polymetal International (POLY) stands to be a serious challenger to the mega cap players. It has a very close eye on economics and says its objective is to ‘limit capital exposure and ensure higher return on capital invested’.

This is encouraging but there’s high risks to the investment story. Firstly, all of its mines and development projects carry political risk due to their locations. It also has geologically-complex assets that require special processing. While that incurs high costs, it does open Polymetal up to further assets that most miners have shunned, thereby giving it a competitive advantage.

It is generating good free cash flow hence why it should continue to pay dividends. A $619 million acquisition of a gold project in Kazakhstan three months ago could raise the miner’s output by 30% within five years. It may make further payments of up to $500 million depending on its share price and the value of gold over the next seven years.