Buying stocks when there is “blood on the street” is easier in theory than in practice. Even hardened contrarians have struggled to buy small- and mid-cap resources in the past year, despite signs that the worst for the resource sector might have passed.
Resource bulls say the sector is turning. The S&P/ASX 300 Metals & Mining index is up 3.5% this calendar year on a total-return basis (including dividends). That compares with an almost 6% drop in the S&P/ASX 200 Accumulation Index.
Wiser heads know this for what it is: a sucker’s rally in a bear market in resource stocks. Granted, the sector looks cheap with many mining and energy stocks trading at decade low, despite some commodities starting to find a floor. Unrelenting pessimism and investors ignoring the sector is another positive for contrarians.
But finding a catalyst for a sustainable re-rerating in the resource sector is hard. Global growth remains fragile, emerging-market concerns are growing, and the 12-month outlook for commodity prices is patchy at best. The tailwind of a lower Australian dollar, a boost for local gold producers, is losing strength as our currency rises against the Greenback.
BHP Billiton (BHP) and Rio Tinto (RIO) are likely to report lower iron-ore shipments this year and analysts continue to lower forecasts for resource-sector earnings and commodity prices. Moody’s downgraded Fortescue Metal Group’s (FMG) credit rating by one notch in March.
So if the mining majors are still heading lower, what hope is there for small- and mid-cap resource stocks that generally have lower-quality assets and higher production costs? They also have less capacity to raise debt or issue equity without excessive share-price dilution.
My hunch is we have not seen the final washout that characterises the end of a massive bear market in resource stocks. The best time to buy resource stocks is when quality companies stop investing in new projects and weaker ones are collapsing or selling their best assets at fire-sale prices. That time is getting closer, but not here just yet.
That does not mean investors should avoid all small- and mid-cap resources. The best opportunities usually emerge when investors give up on sectors and take a blinkered view. It does mean, however, that prospective investors in small- and mid-cap resource stocks need to understand that risks remain elevated, despite the carnage over the past year.
Do not assume the sector is due for a period of strong outperformance after five years of chronic underperformance. The mining sector has underperformed by almost 20% annually over the past five years (on a total-return basis), based on a comparison of the Metals and Mining index and ASX 200 index. That underperformance can continue.
Caveats aside, some parts of the resource sector look more interesting for bargain hunters, and others have less appeal. I cannot get excited about bulk metals and minerals, coal in particular. Base metals have mixed prospects; precious metals look okay.
The worst for the energy sector might have passed, or at least is much closer. And some mining-services stocks, an almost forgotten part of the market, are worthy of further investigation.
Here are three ways to play small- and mid-cap resource stocks.
1. Gold
I have had a favourable view on gold for the past year and a preference for investing in gold bullion (via commodity exchange-traded funds) over gold equities. The main rationale was that increasingly volatile financial markets and gold’s traditional role as a store of value, as global currencies were debased, would drive the precious metal higher.
I expected the Australian dollar to decline against the Greenback in 2015 and benefit local producers through a higher Australian dollar gold price. The S&P/ASX All Ordinaries Gold Index did not disappoint with a 34 % total return over 12 months. Gains are much needed for gold bulls given the sector’s horrific underperformance over five years.
Evolution Mining (EVN) has interesting prospects. It has rallied from 60 cents at the start of 2015 to $1.52. The company had a mixed first half, but continues to reduce costs, improving margins and lowering debt.
Chart 1: Evolution Mining
[1]Source: Yahoo!7 Finance
Evolution upgraded FY16 production guidance to 770,000-820,000 gold ounces, and reduced its all-in cost guidance to $A970-$1,020 per ounce. With the Australian dollar gold price at $1,634, it has scope to grow profits as production and margins expand. Evolution is trading a touch below fair value at $1.53 and could be a takeover target for an offshore gold producer.
2. Energy
Trying to second-guess the oil price is a mug’s game and there are growing concerns that the market will remain in oversupply in 2016 and drive prices lower again, if Saudi Arabia refuses to freeze oil output and join several other major producing countries.
However, it may be posturing and a rapid supply response should help restore some equilibrium to the oil market and boost prices in the next 12 months. Respected US market watcher Byron Wien recently called the oil-market lows as a “major bottom”.
I favour AWE (AWE) among smaller Australian oil stocks. The $290 million company has oil and gas exploration and production projects in Australia, New Zealand and Indonesia. Like other oil stocks, AWE has been slaughtered over 12 months, falling from $1.60 to 53 cents.
Chart 2: AWE
[2]Source: Yahoo!7 Finance
Every stock has its price. AWE has a good record of project delivery, long-life gas fields, and strong leverage to any recovery in energy prices. It has higher-quality assets than most mid-tier energy stocks and, as such, could be a takeover target for a larger player.
AWE needs a rising oil price to be re-rated given its higher operating costs compared with energy majors such as Woodside. A new CEO in David Biggs is another factor for investors.
Morningstar values AWE at $1.60, or more than three times the current share price, but has upgraded the uncertainty rating for the company’s valuation from high to very high. Speculators who believe the oil price cannot head much lower from here will be attracted to AWE. It has a decent rally ahead if the oil price can mount a more sustained recovery.
3. Mining services
Few sectors felt the brunt of the resource recession more than mining and energy services stocks. Once a market darling, the sector has been decimated as mining companies cut, suspend or defer exploration, reduce production, and renegotiate supply contracts. Buyers have all the bargaining power in a market that was once a seller’s paradise.
Monadelphous Group (MND), once one of the market’s best-rated mid-cap stocks, is a better play an eventual slow recovery in mining services demand, compared with smaller operators that have strained balance sheets and uncertain prospects.
Monadelphous has fallen from a 52-week high of $11.75 to $6.80. It traded above $26 in January 2013, but like other service providers has suffered from falling profits.
Chart 3: Monadelphous
[3]Source: Yahoo!7 Finance
It reported a 38% decline in first-half FY16 profit to $37.6 million, flagged a 25% drop in FY16 revenue, expects conditions for mining-services companies to remain challenging. It is hard to see an end to Monadelphous’ earnings downgrades, given deteriorating industry conditions.
All of the 14 brokers who cover the company have hold or sell recommendations. A median share-price target of $6.03 suggests it is still overvalued.
The market might have become too bearish on Monadelphous. It still has a solid balance sheet with $182 million of net cash and the firepower to buy weakened competitors or diversify the business away from mining and into the faster-growing infrastructure sector. Growth in maintenance contracts is another opportunity.
Monadelphous is trading at a significant valuation discount (based on forward Price Earnings multiples) to its nearest peers: Downer, CIMIC, RCR Tomlinson, Transfield Services, UGL and WorleyParsons. It has a case to trade at a small premium given its long-term record, balance-sheet strength and expected 7.3% yield before franking in 2016-17 based on consensus analyst estimates.
It would help if Monadelphous lifted its exposure to infrastructure, an industry in which its peers have greater presence.
All up, there’s no compelling reason to buy Monadelphous just yet: the odds favour further shares price falls this year amid ongoing earnings pressure. But value is emerging. Share-valuation service Skaffold calculates Monadelphous’ intrinsic or true value at $10.61 share – a 36% safety margin to the current $6.80.
Investors might watch and wait for better value in Monadelphous in the next six months. Buying high-quality companies in sectors that are horribly out of favour has a habit of paying off for patient, long-term investors.
– Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at April 6, 2016.
Important: This content has been prepared without taking account of the objectives, financial situation or needs of any particular individual. It does not constitute formal advice. Consider the appropriateness of the information in regards to your circumstances.