Sent: 29-07-2013 10:59:02
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Resource Sector Share Weakness Poses Question for Investors
Widespread liquidation of listed resource sector investments has resulted in extraordinarily depressed share prices for the bulk of stocks leaving value oriented investors battling to distinguish between 'cheap' and 'worthless'.
During 2012/13, the median return among the one thousand or so ASX listed resource companies was minus 50% and the small cap resources share price index, the most representative measure of sector performance, lost 48% after having already given up 33% in the previous 12 months. One quarter of the stocks in the sector fell by 70% or more in the last financial year.
Charts of some of these performance differences can be seen in my daily market comment at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm.
What's gone wrong?
The downward track of share prices has been fostered by an almost perfect storm of hostile conditions coming into 2013:
- a normal cyclical downturn in commodity prices as available production has caught up with and then exceeded demand;
- an expanding number of companies fighting over a shrinking pool of funds due to the financial crisis in Europe;
- an aging cohort of private investors with changing risk profiles quitting resources related investments to fulfill their objectives elsewhere;
- increasingly tough geological conditions which have shown up more strongly in the most recent cycle to make development planning more time consuming and capital intensive;
- a wafer thin skill base as hundreds of competent technical operators have become their own CEOs in a ballooning number of companies;
- too few examples of success to encourage investors to stay in the sector with even the most successful companies failing to meet commercial and development deadlines, often by years rather than weeks or months; and,
- outstanding investment returns elsewhere, including dividend yielding high profile industrial and consumer brand companies.
Does the sector offer anything better in the future?
There will be another cyclical upturn (just as there always has been). Cycles will persist as long as supply side responses cannot be co-ordinated with changes in demand for raw materials. Commodity prices and equity values could increase just as explosively as in any earlier cycle in part because of the adverse impact on future production of the current shortage of development capital.
A reversion to more normal historical relationships offers the chance of some outstanding returns. Over the last 12 months, the handful of large cap resources stocks has outperformed the small stocks in the market by an unprecedented 50 percentage points. The small cap resources companies have fallen short of the S&P/ASX 300 by 65 percentage points. There is scope for these gaps to be narrowed even if not closed.
Those companies most leveraged to even a slight improvement in macroeconomic conditions could show some outstanding short term returns even in the trough of a cycle. Over five days this month, for example, the ASX listed Brazilian nickel miner Mirabela Nickel experienced a share price increase of over 90%. Occasionally strong returns can be found as the cycle matures and investors begin to anticipate better conditions, even if too optimistically at first.
More value oriented investors contemplating the sector are going to ask whether there is anything of value amid the evident misery, aside from these short term trades or having to wait for the next cyclical upturn.
Since project delays have become such a prevalent part of the sector landscape, the lengthening gestation period for resources sector projects is now extending well beyond the duration of an economic cycle.
The difference in the timing between project gestation and cycle duration makes it increasingly tough for an investor to come in early on the development schedule and not have to face some heavy losses before an investment comes right.
Prices should fall (if they have not already done so) to a level that compensates for the risk and the opportunity cost in staying with an investment through the cycle. This market adjustment is a part of the explanation of the price action over the last two years.
Taking this timing gap into account, investors should assume a cyclical downturn at some stage along the development path for even ultimately successful large to moderately sized projects. Lower equity prices accompanied by highly dilutive capital raisings need to be assumed to figure the price at which an investment with a multi year development horizon makes sense.
Sundance Resources is a case study of many of the problems associated with the most recent cycle. The current management has recently commenced a concerted effort to arrange funding for the $5 billion west African iron ore and infrastructure project.
Unbelievably, earlier management had once claimed it would be producing iron ore in West Africa by 2011. Sundance directors spent two years or more courting a Chinese partner from whom it had sought funding before being jilted. Now, greatly de-risked, 2017 is probably the earliest it can begin production but, all going well, the company offers investors a world class project.
The financial performance of Sundance, once full scale production commences, remains conjectural but a net profit around $950 million could be possible at an $85 per tonne iron ore price, based on what the company says about its prospective cost structure. The project itself could be funded from non equity sources (which the company is aiming to put in place during the current half year) but the company could have to raise as much as $100 million more in equity along the way to survive.
Even after the dilutive impact from raising more equity, 20 cents per share in earnings could be possible. Paying five times earnings for a long life project, not unreasonable even in poor market conditions, would imply a one dollar share price in five year's time for a business currently trading near 8 cents.
Sundance is hardly typical in terms of the quality and scale of the targeted project but it does illustrate quite starkly the dilemma posed by the sector for investors. It does offer value. Given a long enough investing horizon, the returns may well prove more than adequate to compensate for the risk. There might be no alternative to the plans being pursued by the current management.
However, the development timeline is so long that the challenge posed for investor patience may be too great. Critically, with so few examples of the wait paying off, investors may just conclude that cheap is synonymous with worthless and move on to something else.
(John Robertson is a director of E.I.M. Capital Managers, a Melbourne-based funds management group. He has worked as a policy economist, corporate business strategist and investment market professional for over 30 years after starting his career as a federal treasury economist in Canberra. His daily Market Diary - Brief Thoughts on Current Issues is available at http://www.eimcapital.com.au/PortfolioDirect/daily_views.htm).
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