Rudi’s Response: Are Mining Services Providers Offering Bargains?

This story features MONADELPHOUS GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: MND

By Rudi Filapek-Vandyck, Editor FNArena

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Shares of mining services providers have been significantly de-rated since the second quarter of 2012. In recent weeks the sector has again suffered from funds outflows causing yet another wave of large sell-offs. Market commentators and investment experts are now suggesting there are bargains to be found throughout the sector. FNArena received questions from subscribers whether this stock or that one is a genuine value opportunity.

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Maybe I am showing my naivete, but when I talk and write about an "investment opportunity" I tie this in with the ability to research and assess what might happen in the future, and with a certain degree of confidence that projections about the future may not differ too much from the actual outcome.

After all, that is, in its very basic concept, the key difference between "investing" and "taking a punt", or gambling if you want.

There is no doubt in my mind that certain segments of the Australian share market are now in a protracted down-trend. I would have thought everyone agrees engineers and services providers to miners and energy companies are today the most logical sector that springs to mind given the radical switch towards capital preservation and cost reduction among their customers, but it appears this is not so.

First, let me explain the nature of what will be a multi-year downtrend for the industry. As things stand right now, capital expenditure as expressed in dollars ("total value") is likely to plateau between 2012 and 2014, after which a much sharper drop off is likely. This is partially the result of already commissioned, large projects that are progressing into the final stages of development, and which are all suffering from significant cost over-runs, and the relatively new drive throughout the resources industry to cut costs, allocate capital in more profitable ways and to please shareholders that haven't seen much in terms of returns since 2006.

What this means is essentially that the worst for the industry may well still be two years ahead of us, regardless of share price action today.

For most companies in this segment, visibility in terms of new orders and earnings growth is not great during the best of times. It is probably at its absolute worst right now. I am confident even the highly regarded, very experienced management team at industry bellwether Monadelphous ((MND)) has no concrete clues about what lies ahead for the next two-three years. They're the best in their class, so they'll probably stay profitable with a high quality balance sheet, but remember the share market is all about "growth". I would not discount the fact that dividends will have to be cut, and possibly quite significantly so, because of the many pressures during this general downturn.

My question to all investors and experts who are now trying to find bargains amidst the down-beaten share prices is: if even the managers running these companies have no idea what is going to happen, and their customers seem hellbent on reducing their operational costs, how confident can we outsiders be about what might happen in a few years' time?

It is for this reason that I believe these companies -the sector in its entirety- has lost the label of "investment grade".

What happens when such a clear downturn announces itself is investors flee towards other opportunities and share prices suffer severely. It is probably a fair comment to make that most share prices will invariably end up too low, but real value can only reveal itself when this downturn has run its course. Don't think for a second that Price-Earnings (PE) multiples will trend back to more normal levels until some kind of visibility, normalisation and confidence are back on the agenda.

It is my observation that what happens is all those lowly valued companies instantaneously become the hunting ground for day-traders and short-term speculators. This makes a lot of sense because beaten-down share prices obtain the ability to jump up very high on any piece of good news – sometimes simply on the lack of negative follow-through.

In all fairness, there is a good argument to be made that value investors should zoom in when blood is running through the streets and there's no doubt some of today's share price valuations appear extremely attractive. But that's on the basis of today's assumptions and projections. We don't know what is yet to happen from mid-2014 onwards.

It's not that investors have no recent precedents to draw valuable lessons from. Gold miners have been de-rated for the past two years and every pause during the process drew from the sidelines a whole army of enthusiastic experts and investors ready to jump on what appeared to be obvious value opportunities. Those investors are today, virtually without exception, licking their wounds. Alternatively, ask any investor in uranium stocks what it means to jump on value opportunities with the wrong timing.

Of course, it is possible that a few companies will manifest themselves as the exception during the years ahead. After all, when retailers en masse received the thumbs down from investors in the years past, both Super Retail ((SUL)) and The Reject Shop ((TRS)) proved the exception and both delivered handsome rewards to loyal shareholders, despite general scepticism from investors and notwithstanding the dire circumstances for most of their peers.

Just ask yourself: what are the odds that you can pick the equivalents of those two retailers among the fifty or so beaten-down pick and shovel services providers, without also picking the occasional value trap that can ruin all your good efforts in one bad day's time?

In my eBooklet, "Making Risk Your Friend. Finding All-Weather Performers"^(*), I argue that good investing starts by making good judgments about risk. This is why I happily leave this sector to enthusiastic day-traders, algo-robots and high-risk tolerant investors with a short time frame.

It is my assessment that anyone with a different profile need not apply today. At their own peril. Until industry dynamics start changing for the better.
 

(*) The eBooklet (58 pages) "Make Risk Your Friend. Finding All-Weather Performers" was published in January this year and is offered as a free bonus to paid subscribers (excl one month subs). If you haven't received your copy as yet, send an email to info@fnarena.com

(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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