A Chorus of Buys

Don't be fooled by media reports suggesting Australia's leading equity brokers have gradually scaled back their buy recommendations as the local stockmarket steered to new highs in 2006.

At FN Arena we keep a daily watch on 10 leading equity researchers and advisers. We have not noticed any reduction in the relative amount of buys over the past months. In fact, the opposite has happened, with the total number of neutral recommendations falling below 50% on Monday morning (to 49.95%), taking total buys to 36.88%. We can’t remember the number of buy recommendations ever being as high over the past four years as it is now.

How to explain this? I think there is only one logical conclusion to draw: the idea of a super cycle for energy, industrial metals and other commodities is still very much alive inside the investment community.

As the world received a major scare from global inflation potentially picking up while interest rates may go higher still and economic growth is slowing, prices of listed shares and commodities took a plunge over the past few weeks. The response from the local investment experts has been as straightforward as can be: recommendation upgrades for individually listed stocks have been twice as high as the amount of downgrades for two weeks in a row.

Take Alumina Ltd (AWC) for example. Alumina is the highest recommended stock in our universe. Only Aspect Huntley does not rate it a buy. The difference between Friday's closing share price and the average 12-month price target is more than 20%, dividends not included.

A little below Alumina, we find BHP Billiton (BHP), Rio Tinto (RIO), Oil Search (OSH) and Hardman Resources (HDR). Even Newcrest Mining (NCM) is back at the top, with its average price target suggesting shareholders should see 28% in share price appreciation alone over the coming months.

The secret behind all this can be found in the lag between spot commodity prices and what the experts put through their valuation models. Even after the sharp sell-off in commodities, the average price forecasts used by securities analysts to value resources companies are still below today's spot prices. So what can they do other than upgrade their recommendations when share prices take a dive?

The time will come when these experts start scaling back their future estimates, but for the time being all we see is further price increases. Aspect Huntley, always very sceptical about possible bubbles in the market, has been the latest to increase its price forecasts for key commodities.

Expect another wave of increased oil price forecasts as well. Most experts have so far kept their average price forecast for this year to $US60 a barrel, but the first five months saw an average WTI (West Texas Intermediate) spot price of more than $US65. Every day the spot oil price remains near or above $US70 a barrel strengthens the likelihood that analysts will succumb to the reality that the price won't go down to $US50 a barrel anytime soon.

ABN-Amro's team of metals and mining experts, also very sceptical towards too-rosy expectations regarding the super cycle and spot prices, cited another reason on Friday why resources companies remain a valuable investment option amid the May turbulence: prices of bulk commodities, such as iron ore, traditionally peak later than base metal prices.

The recently achieved 19% price increase for the year to March 2007 by Brazil's Companhia Vale do Rio Doce (CVRD), Rio Tinto (RIO) and BHP Billiton (BHP) may be further proof of this. We have seen no market expert confidently predicting contract iron ore prices will decline next year. Some, like Credit Suisse, suspect there may still be another small price rise before the balance of power shifts towards the demand side again.

It is for this reason that most of the experts would advise investors to focus on the large diversified resources giants from now on. This year's negotiations with steel manufacturers have resulted in a better-than-anticipated 19% price increase, even though the Chinese are still holding out for a better deal.

But here's a reason why the next leg-up in resources stock prices is unlikely to remain confined to just the bigger players: the likes of BHP Billiton and Rio Tinto are currently generating so much cash, they hardly know what to do with it. Even though their average price targets imply a return of 20% or more, special dividends or other forms of capital management not accounted for.

More importantly, there is a real chance the surplus cash might cause management of these companies to consider buying other assets, especially now that share prices across the sector have come down again.

Investors willing to speculate on a potential takeover bonus are advised to look for quality assets, with perceived manageable risks, so mines already in operation are preferred.

Companies that are regarded highly attractive as potential takeover targets are Oxiana Resources (OXR), Iluka (ILU) and Kagara Zinc (KZL). There's obviously the attraction of Newcrest Mining (NCM) to the bigger North American gold producers as opposed to Lihir Gold (LHG) for which takeover appeal is considered very low given the difficult geographical circumstances under which its sole gold mine has to operate.

Some of the junior explorers such as Exco Resources (EXS) or a junior miner such as Universal Resources (URL) are mentioned on a regular basis as potential targets for the likes of Xstrata as well. All in all there seem to be enough reasons not to give up on resources as an equity investment just yet.