Resources Stocks: (A Lot More) Patience Required

This story features REGIS RESOURCES LIMITED, and other companies. For more info SHARE ANALYSIS: RRL

In this week's Weekly Insights:

– Resources Stocks: (A Lot More) Patience Required
– Rudi On Tour
– Rudi On TV

Resources Stocks: (A Lot More) Patience Required

By Rudi Filapek-Vandyck, Editor FNArena

If this is the early beginnings of the long anticipated turnaround for resources and for resources stocks, then, by golly, the sector has a wicked way of spreading welcome signals to investors.

Commodities, as a group, have suffered price falls for 3.5 consecutive years and thus far 2015 appears poised to become the fourth calendar year in a row to keep commodities at the bottom of financial asset performances.

Surely, by now, every investor with a smidgen of "contrarian" running through his veins is looking at the sector with full anticipation, ready to pull the trigger and reap significant gains?

Not so.

On my observation, many a market participant has pretty much given up on the sector and has shied away from adding exposure even with share prices falling to ever deeper levels. There are always commodity bulls around, of course, as well as traders looking for the next short term opportunity. Commodities will always combine with day-to-day volatility and with sharp rallies, short term or otherwise, hence there's always "opportunity" begging to be monetised, be it in nickel, or in alumina, or in gold, or in lithium, or in the energy sector.

For investors with a longer term horizon, however, the past four years have been one tough enduring challenge to sustain. Combine BHP Billiton's share price with South32 and you still only get circa $28.60; double digit percentage below where the stocks sat at the start of what is commonly seen as the next bull market for global equities in March 2009 (luckily loyal shareholders have received steadily growing dividends over the period).

Share prices do look "cheap". Few analysts/experts/investors will deny this much. Add depressed trading volumes and a build-up in shorts (admittedly more so in the second derivative, the contractors and services providers) and you'll witness the occasional 27% share price surge in one day as did goldminer Regis Resources ((RRL)) when it announced a surprise dividend plus share buyback on Friday.

So why is a sector littered with "cheap" valuations not attracting more interest from investors and positive commentary from macro-analysts and investment strategists?

It's simple, really: the outlook fails to excite.

More Of The Same In FY16

Commodity analysts at Commonwealth Bank are the latest to update price forecasts for base materials and they have done the same thing as every single one of their peers has done thus far in 2015: lowered forecasts.

In CommBank's case, iron ore, thermal coal, hard coking coal and manganese received the largest downgrades, made worse by the fact the analysts continue to see more downside risks for iron ore, manganese and coking coal. But what should really have investors' attention is that CommBank analysts, on average across the spectrum, see further price declines for the year ahead. No surprise, the title of their sector update reads "FY16 to look a lot like FY15".

Analysts at Macquarie, who went through a similar exercise some weeks ago, last week tried to explain to investors what really is holding back industrial commodities. It's not so much to do with sluggish global economic growth or with credit stress in China, or slowing Chinese demand, or a seasonal slump in demand. All these factors do have an impact, of course, but what is really weighing on prices is too much supply and little signs of high cost producers going out of business or low cost producers making cuts.

Macquarie is blaming QE, otherwise known as "cheap money".

In past cycles, point out the analysts, markets would have seen permanent supply cuts at marginal operations to help bring markets back towards balance. However, over the past five years these have been few and far between. "Essentially, the prevalence of cheap money has meant we have not let conventional economics work in forcing supply out".

The end result is one long and hard slog for markets to work through in order to achieve better balances between demand and supply.

Not all markets are in the same situation, but most are. Macquarie analysts put together a diagram picturing where twenty individual commodities are positioned in the quest for rebalancing, plus their outlook for the next two years. It's not a pretty picture, unless you are looking at it through the eyes of an end-user (in which case your optimism has just received a big boost).

Mining Stocks Seldom This "Cheap"

Analysts at Goldman Sachs reminded their clientele recently about the old adage that commodities stocks are best bought when at high Price-Earnings (PE) multiples and sold when those multiples are much lower.

Within this context, the analysts observed the mining sector listed on the ASX is now trading at a forward looking PE multiple above 19x. Historically, this is a rare occurrence, note the analysts. Over the past thirty years the sector has only traded on a PE of 19x or higher five times (1993, 1997, 1999, 2003 and 2009).

So what can we learn from the five precedents?

In short: despite the forward PE multiple indicating the sector is now extremely cheap, investment returns over the next twelve months should be rather modest, if not negative, unless profit growth emerges in significant fashion.

This is exactly where Goldman Sachs analysts see the problem for today's mining stocks. Market consensus forecasts are that miners and energy producers will report abysmal results in August, but also that profits should pick up at accelerating pace into 2016. Goldman Sachs thinks this is going to be proven too optimistic.

One key factor in these forecasts are commodity prices which until recently were widely forecast to improve from here onwards. But every single sector update is leading to yet another reduction in price forecasts.

One second important factor is the expectation that cost cuts will lead to improved margins for producers. Yet Goldman Sachs believes within the broad context for commodities as it stands right now, any benefit from further cost cuts will be passed on to customers (end users), not to shareholders. Analysts at Macquarie and Citi agree with this view, to name but two of Goldman's peers.

Gold Gripped By Bear Claws

A special mention goes out to gold for which balance between demand and supply does not exist in the same sense as it determines the price outlook for industrial commodities. First, anyone with an opinion about gold might consider the following quote from Howard Marks, chairman of Oaktree Capital Management:

"There is nothing intelligent to be said about gold. Nobody can tell you the right price for an ounce of gold. People will tell you it should go up or go down. To make any intelligent statements about investments you have to know what the right price is. You can’t do that with an asset like gold, which doesn’t produce any cash flow. So you can buy it out of superstition or ignore it because you are an atheist but you cannot buy it with an analytical foundation."

To give credit to Marks' opinion on bullion, it certainly is true gold tends to surprise both friend and foe whenever it feels like it. Earlier in the year many a gold miner saw its share price double with no apparent catalyst in sight. In recent weeks macro-economic stress picked up significantly with Greece on the brink of total mayhem and the Chinese stockmarket in a downward spiral, but gold only halfheartedly responded in a rather weak fashion.

I remain of the view it all makes a lot more sense when viewed from the angle of Federal Reserve policy expectations. Owning gold today means you are betting against Janet Yellen and Co raising interest rates in September. As market expectations are firming in favour of a first rate hike in September, it is but logical the price of gold is taking a hit. All the rest is but noise, really.

See also this previous analysis on gold: Fool's Gold? Know Thy Enemy!

Focus On Progressive Dividend Policies

Four years of downward trending commodity prices, two if we focus on iron ore and crude oil, are taking a toll on the big miners' ability to maintain progressive dividend policies through the cycle. Thus far none of the board members at either BHP Billiton ((BHP)) or Rio Tinto ((RIO)) has indicated whether abolishing the policy could be on the agenda, at some point. Given the concept of dividend support has become more of a fluid concept for both share prices over the past twelve months, the market clearly is suggesting the idea must be at least on board members' mind.

Judging from recent analysts' reports, opinions diverge on the matter. Some analysts don't see cash flow being sufficient to pay out higher dividends this year and next, others think there's no problem even if prices remain lower for longer. None think either BHP or RIO will cut its dividend. Some analysts have penciled in stable dividends (unchanged from the previous year) either this year for RIO or this year and next for BHP. This would de facto imply scrapping current progressive policies which have been in place since most of us can remember.

Meanwhile, it remains an open question whether current shareholders of Woodside Petroleum ((WPL)) are prepared for what is likely going to be one massive cut in dividend at the upcoming half year report. Current consensus expectation is that full year dividend will drop by more than 50% for the year to December 2015. But not everyone has access to an Iress or Bloomberg terminal (or to FNArena) so it'll be interesting to find out the general response post the announcement. Also, analysts at Macquarie and Morgan Stanley are positioned much lower than market consensus, so there's room for surprise, either way.

Also, at this point most analysts anticipate a one-off reset to a lower dividend payout for Woodside (80% of much lower profits), with a renewed uptrend to start in 2016. Helped by a (widely anticipated) much lower Aussie dollar, this means the yield in 2016 could surge well past the 5%. But first investors will have to stomach a lower dividend this year.

Trading Opportunity?

Investors (more likely: traders) might pay attention to the fact JP Morgan's market timing model has switched to favour Resources equities relative to Financials for the week(s) ahead, following six weeks of underperformance for Resources relative to Financials.

JP Morgan's model is not guaranteed to be 100% accurate but as an observer from the sidelines I can confirm the model has been quite accurate this year, further supported by the fact it has mostly favoured the Financials during the first six months of 2015.

Rudi On TV

– on Wednesday, Sky Business, 5.30-6pm, Market Moves
– on Wednesday, between 7-8pm, Switzer TV
– on Thursday, Sky Business, noon-12.45pm, Lunch Money

Rudi On Tour

I have accepted invitations to present:

– August 2-5, AIA National Conference, Surfers Paradise Marriott Resort and Spa, Queensland – for more information about this event:

http://www.investors.asn.au/events/events-schedule/aia-national-investors-conference/

Note: FNArena subscribers can attend at similar discount as AIA members

(This story was written on Tuesday, 21 July 2015. It was published on the day in the form of an email to paying subscribers at FNArena).

(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. All views are mine and not by association FNArena's – see disclaimer on the website.

In addition, since FNArena runs a Model Portfolio based upon my research on All-Weather Performers it is more than likely that stocks mentioned are included in this Model Portfolio. For all questions about this: info@fnarena.com or via Editor Direct on the website).

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THE AUD AND THE AUSTRALIAN SHARE MARKET

This eBooklet published in July 2013 forms part of FNArena's bonus package for a paid subscription (excluding one month subscriptions).

My previous eBooklet (see below) is also still included.

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MAKE RISK YOUR FRIEND – ALL-WEATHER PERFORMERS

Odd as it may seem, but today's share market is NOT only about dividend yield. Post-2008, less risky, reliable performers among industrials have significantly outperformed and my market research over the past six years has been focused on identifying which stocks, and why, are part of the chosen few; the All-Weather Performers.

The original eBooklet was released in early 2013, followed by a more recent general update in December 2014.

Making Risk Your Friend. Finding All-Weather Performers, in both eBooklet versions, is included in FNArena's free bonus package for a paid subscription (excluding one month subscription).

If you haven't received your copy as yet, send an email to info@fnarena.com

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