Rudi’s View: The Big De-Rating – A Guide Through The Minefields (4)

This story features RIO TINTO LIMITED, and other companies. For more info SHARE ANALYSIS: RIO

By Rudi Filapek-Vandyck, Editor FNArena

International large diversified mining companies have allocated more cash for investments in new projects and expansions of existing operations in the next five years than they spent over the past fifteen. Add explosive growth in future gas infrastructure the world around and it should be clear: there's a bonanza going on and there's one easy to identify group of companies that is going to benefit from this: engineers and equipment sellers, providers of services to miners and energy companies; the modern day equivalents of the traditional sellers of picks and shovels.

Too many investors have been solely focusing on the miners, the oil producers and the hopeful explorers during the first phase of this commodities boom. This has, inside the context I explained in the three previous chapters in this series, mostly resulted in sub-optimal investment results. Want proof? In February this year I compared total investment returns for a simple Buy-and-Hold strategy between shares in Rio Tinto ((RIO)) and in David Jones ((DJS)). It turned out David Jones' return since 2003 was more than 100% higher (fact).

However, if we add Monadelphous ((MND)) to the comparison the picture once again changes completely. Like David Jones, Monadelphous shares were trading around $1 back in early 2003. By November 2011 that share price has multiplied to $19. In other words: if shareholders in Rio Tinto looked forward they would distinctly see some dust coming their way, left behind by the nimble (but high dividend paying) David Jones. But both would be hoping the race was not run in circles because Monadelphous would have come around and left both behind and come around again and left both behind so many times, it can only be described as embarrassing.

Probably the best way to illustrate the supremacy of Monadelphous shares over the period is that the company is going to pay out more than $1 in (fully franked) dividends to its shareholders in the present fiscal year.

Admittedly, Monadelphous is not only the best of its kind, it may just as well have been the best stock to own in the Australian sharemarket over the past eleven years. This does not take away the fact that there is one clear message here for investors: if you want to play the Emerging Markets/Commodities Super Cycle theme, don't buy the miners and the energy companies who take on all the risks and carry all the burdens of the upswings and downswings in the cycle; follow their money instead.

Most of the monies spent end up in contract revenues at companies such as Monadelphous. Two of my other personal favourites in the Australian share market, Fleetwood Corp ((FWD)) and Campbell Brothers ((CPB)) are essentially in a similar position. All three have significantly outperformed their customer base in terms of investment returns over the past years and if we include dividends paid (as we always should) then all three have more than recouped their losses for loyal shareholders post the 2008 sell-down.

Note the benchmark for funds managers and financial media, the ASX200 index, is down some 8% from January 2011 and still circa 40% below its peak from November 2007.

The most remarkable side of this story is this strong performance has been supported by rather modest growth numbers. The Benchmark for the sector, Monadelphous, has been improving its earnings per share by a little over 10% each year post 2007, not by 75% like BHP Billiton ((BHP)) achieved in FY11 or by close to 100% as Rio Tinto ((RIO)) is expected to achieve for the year ending this December. This has been the case for most of Monadelphous' peers. (Campbell Bros is currently experiencing an exceptionally strong year, but forecasts are for its growth to fall to mid-teens percentages in following years).

This observation is more important than you think. It's what these companies have in common with the all-weather performers I described in Chapter three (published last week).

A few weeks ago ex-Wilson HTM stockpicker Matthew Kidman appeared on financial television to promote his book "Bulls, Bears and a Croupier". Kidman has similar views about what's been happening in the share market as the ones described in previous chapters and he likes similar stocks. But what caught my attention most during the interview was Kidman's statement he had spoken to many advisors and market strategists in recent times, and none knew how to deal with the current environment.

Obviously, there are some hard lessons being learned and not just by lesser experienced DIY retail investors. Lesson number one: a healthy and robust economy does not automatically guarantee a similar performance for the local share market. Lesson number two: the sector with the highest growth potential does not always perform best, the company with the highest growth does not necessarily provide the highest investment return.

The key factor in all this is "confidence".

While Rio Tinto may well report in February it will have almost doubled its earnings per share in 2011, clearly growth will be much, much lower in the years ahead. The exact growth achievable next year(s) remains to be seen, but already the first analysts' estimates have been spotted that assume no growth for the next two years. I'll happily repeat this one, just to get the message across: zero growth for the two following years. Even if this were proven incorrect in 15 months' time, it still shows the fickleness and the leverage that are inherent in projections for miners. Enough to attract a stamp of "no confidence" when risk appetite exits the market.

Which brings us to the crux: where does this confidence come from?

When the board of a miner or energy company decides to go ahead with a multi-billion dollar investment, this is not a decision that is decided upon lightly. Now imagine the odds the investment is nullified once the first $100m in contracts has been awarded… It does happen, however, as we have seen in the Oakajee saga in Western Australia where ever rising costs eventually forced the hand of the Chinese investor. This is why Mr Market is prepared to pay a premium for those contractors who work for a select group of members of the world's upper corporate echelon; BHP Billiton, Chevron, Rio Tinto, Anglo American, Xstrata, RD Shell,…

Clearly, the risks are higher for projects that need to be financed by junior miners and energy companies. It should also be clear that whenever global risk appetite freezes, as it has done in 2011, these junior companies do find it tough to attract any form of funding.

The most important aspect of this story remains, however, that most contracts in the pipeline are yet to be rewarded. Ongoing uncertainties, not just because of European banks and sovereign debts, but also because of heavy swings in commodity prices, Chinese authorities clamping down on property excesses, government interventions (extra taxes and fees) and global growth ahead have been pushing many projects further into the future. So what was originally meant to be a 2011 story has now (hopefully) become more of a 2012 story. This doesn't mean there cannot be more delays and suspensions.

The underlying theme however remains intact: unless we are about to witness a biblical Armageddon, the next years will see billions being spent on new mines, wells, equipment and infrastructure and companies that cater for such projects should be able to secure contracts and growth for years to come.

It's sufficient to instill investors with enough confidence to keep buying shares in high quality names such as Monadelphous, Fleetwood and Campbell Bros. Up to the point that all three, and others, are regularly overvalued on near-term valuation metrics. That remains problem number one for stocks in this segment of the market: investors can get impatient at times as witnessed by a general rise in share prices in Q4 of 2010, only to see most share prices fall back a few months later, when it dawned on many investors they had been a bit early. For all we know something similar is taking place in Q4 this year. Will it still be too early? We'll have to find out in 2012.

Even if 2012 turns out to be the first cracker of many more such years to come, investing in this segment of the market comes with higher than usual risks as many of these companies share in project risks or need extra funds to expand (not to mention the stress of finding extra skilled labour). Investors are being reminded that Downer EDI ((DOW)) is also a member of this market segment, as is Leighton Holdings ((LEI)). We could also include Nomad Building Solutions ((NOD)). All three have been capital removers instead of wealth builders for shareholders in recent years.

On my estimation, there are probably around 100 companies on the ASX that can be considered a member of this segment (and thus a potential direct beneficiary of record spending by miners and energy companies in years to come). This number grows every day as companies from other sectors are redirecting their operations towards this flood of yet to be awarded contracts. These newcomers include traditional property developers and producers of building materials such as Lend Lease ((LLC)), Adelaide Brighton ((ABC)), Boral ((BLD)) and Watpac ((WTP)).

Below is a selection of stocks I think deserve investors' attention for the years ahead. Note that while I left out many, this doesn't automatically imply that all the ones mentioned carry my personal endorsement. I strongly suggest investors conduct their own research and further analysis. In addition to the stocks mentioned in chapter three, I think investors can do well in the share market in years ahead if they buy some of these stocks at the right prices, not to trade them but to own in a long term investment portfolio..

Stocks that should be on investors' radar (in no particular order):

– WorleyParsons ((WOR))
– NRW Holdings ((NRW))
– Industrea ((IDL))
– Bradken ((BKN))
– Sedgman ((SDM))
– GR Engineering ((GNG))
– Lycopodium ((LYL))
– Imdex ((IMD))
– Norfolk Group ((NFK))
– Ausdrill ((ASL))
– Fleetwood
– Monadelphous
– Campbell Bros
– and others

Investors can also read "Winners And Losers" (June 27, 2011)  and "Top Picks In Engineering And Contracting" (September 8, 2011).

This series is expected to conclude with a final chapter next week.

(Do note that, in line with all my analyses, appearances and presentations, all of the above names and calculations are provided for educational purposes only. Investors should always consult with their licensed investment advisor first, before making any decisions.)  

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P.S. II – If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

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