Opportunities in resource stocks in 2014

Financial Journalist
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The resources sector is at a crossroads in 2014. After three years of underperformance, metal prices need to snap their downtrend and prove the commodity supercycle is far from over. If they do, resource stocks could be the buy of the decade for long-term investors.

The bear argument

Pessimists argue commodity prices are in a multi-year downtrend, after outperforming developed-market equities in the previous decade. Not unlike tech stocks at the turn of the century, it will take many years to unwind a once-in-a-generation commodity price boom.

As the fuse that lit the boom, China, continues to transition from an investment-led to a consumption-led economy, metals demand will slow, driving commodity prices lower. The rebalancing of China’s economy could be this decade’s defining investment trend, as lower infrastructure investment reduces demand for steel, copper and other key bulk and base metals.

The other challenge is identifying a catalyst to re-rate commodity prices and resource stocks in 2014. The global economic recovery remains patchy and prone to shock, and significant new commodity supply will come on stream in the next few years.

The US Federal Reserve’s decision in December to taper its asset-purchase program by US$10 billion a month, and its dovish guidance on the outlook for interest rates, confirms the US economy is gradually recovering, but still requires significant stimulus for any improvement to be self-sustaining.

Another year or two of subdued global economic growth and benign inflation is hardly the setting for a significant commodity price recovery this year. Gold, in particular, has a challenging outlook given waning expectations of higher inflation (gold is seen as a hedge against rising inflation).

The bull argument

In contrast, resource bulls argue lower commodity prices and the belting of resource stocks in 2013 have already factored in the above scenario – and then some. Iron ore is a case in point: market expectations were for an iron ore price around US$90 a tonne, yet it has stubbornly remained above US$130.

Iron ore stocks, such as Fortescue Metals Group and BC Iron, rallied from their 2013 lows, as the market realised it had been too bearish on iron-ore prices. Fortescue has a one-year total shareholder return of 27%; the impressive mid-cap producer, BC Iron, is up 58%.

The bulls’ other key argument is predictions of vast increases in commodity supplies because of the resources investment boom in the previous decade. But they have been overstated. Lower commodity prices have led to rapid deferrals, cutbacks or cancellations of several key mining projects in Australia and abroad, meaning lower-than-expected new minerals supply in the next few years.

Moreover, a slightly lower Australian dollar in 2014 will give an earnings boost to BHP Billiton, Rio Tinto and other large minerals exporters, although expectations of a weaker dollar probably have been factored into share prices.

BHP Billiton (BHP)

Source: Yahoo

An excellent sign is improved sector discipline. The big producers are making the right noises: greater focus on cost containment, innovation and capital management, and less desire to invest for growth’s sake. The prospect of higher dividends and even special dividends in the resources sector is a significant positive in 2014 and 2015.

Perhaps the bulls’ strongest argument is market sentiment. Smart investors know the best time to buy is when everyone else is selling. That is certainly true of gold, which is at three-year lows. Mining service companies and many junior explorers are also terribly out of favour.

The outlook for 2014

Setting out bull and bear arguments for commodity prices and resource stocks provides context for such a large, diverse sector. I favour the pessimistic view: that commodity prices are in a multi-year downtrend, with sharp rallies likely to feature when the sector is oversold.

There will be decent trading opportunities in big resource stocks in 2014, but good luck if you can get in and out of the sector at the right time. And the rally in several resource stocks in the second half of 2013 has brought the sector rapidly back to fair value.

For long-term investors, such as self managed super funds, the best time to buy resource stocks is when investment in new projects has stalled; the best time to sell is when investment peaks. The resources investment boom is far from over, and several giant resource projects, particularly in liquefied natural gas, are still to come on stream.

Moreover, it is hard to believe such an incredible mining boom can be resolved by three years of commodity price underperformance, before the sector recovers. What is more likely is modest, more-sustainable growth in the resources sector this decade, with gains from volume, rather than price growth, making high-quality resource producers a solid, rather than spectacular, investment in 2014.

Self managed super funds that still want to add resource exposure to portfolios, need to decide between buying commodities, a basket of resource stocks, or individual companies.

Gaining exposure to commodity prices through exchange-traded commodities eliminates company and market risk, and was a smart strategy when prices were in an uptrend. But with commodity prices heading lower over the next few years, it makes sense to focus on companies that can benefit from production and efficiency gains.

Stock-picking skills needed

Focus on a few high-quality producers, rather than “buying the sector” through an exchange-traded fund over resource stocks in the S&P/ASX 200 index. Making money from resources in 2014 will require adept stock-picking rather than chasing sector-wide gains.

I always favour minerals producers over explorers and resource services companies – and especially so now. Lower commodity prices will be a death knell for many marginal, single-commodity exploration companies in the next few years. And the unwinding of the resources investment boom means more trouble for resource services providers – and even lower share prices for many this year.

BHP Billiton offers modest value at $37.77. The rally from the 52-week low of $30.43 has eroded the easier gains when BHP was oversold, and the consensus analyst 12-month share price target is about $37.

I am more bullish, and see BHP trading around $40 within 12 months thanks to higher-than-expected iron ore production and a resilient iron ore price (relative to market expectations) – at least for 2014. A 10-15% return (including dividends) this year looks reasonable, and BHP has potential to surprise on the upside if commodity prices perform better than expected and the Australian dollar retreats. BHP looks better long-term value that Rio Tinto and Fortescue.

For the risk takers

Owning shares in gold miners will not suit most SMSFs. However, the risk takers might find Newcrest Mining an interesting contrarian idea. Although the gold price has a challenged short-term outlook, Newcrest looks reasonable long-term value at $8.67. It has rallied from the 52-week low of $6.96 but it is a shadow of the previous high of almost $25.

Newcrest (NCM)

Source: Yahoo

Newcrest is doing a good job on cost cutting and productivity gains, and its first-quarter production was better than the market expected. This is a company with a lot to prove after a disastrous 2013. For all of its well-documented problems, Newcrest has one of the higher-quality, long-life resource bases in the global gold sector, and an asset that would take decades to replicate. It also has a lot of costs that can still come out of the business, and scope for greater efficiency gains.

Newcrest has a savvy new chairman in Peter Hay and is expected to have a new CEO in the second half of 2014. The consensus 12-month price target of analysts is about $11.

Newcrest looks undervalued after its horrendous falls. Gold has interesting medium-term prospects as the rise of middle-class consumers in Asia leads to higher demand for precious metals, and as inflation becomes a bigger threat in the next few years.

– Tony Featherstone is a former managing editor of BRW and Shares magazines. All prices and analysis at January 5, 2014.

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.

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