BHP and Rio's recovery path

In his article this month Prepare for a resources rush, Tim Treadgold wrote on prospects for the resources sector and the growing view that a recovery was in order.

A seemingly good call when, according to Bloomberg, a growing consensus is emerging that global growth will be at a four-year high in 2014.

I have been bullish on the resources sector and it has been one of my favoured investments. The unfortunate thing is that in 2013 resources BHP, and Rio in particular, who represent by themselves half of our resource stocks by market capitalisation and 10% of the All Ordinaries, have been key underperformers.

In fact, in the top 100 they rank in the bottom. Not quite as bad as Newcrest, with a 67% fall, but at the time of writing BHP was down 4% and Rio 2% for the year, while the All Ordinaries was up 9.2% (and the All Ords Accumulation Index which includes dividends is up 14%). Clearly they haven’t paid off.

Yet, equity investments are made for the longer term and it’s with that in mind that not I’m not quite ready to give up on the sector yet. Indeed, I agree with the broad findings of Tim Treadgold’s note.  The fact is the underlying macro call that has underpinned my optimism for the sector has been the right one – it still is, and that Bloomberg news post suggests this view is gaining traction.  Think of the backdrop now:

• China didn’t have that hard landing and is growing at a very strong pace. Just over the last year China created, in economic terms, another country the size of Australia.
• The US economic expansion is picking up pace.
• There is no supply glut of iron ore or steel.

Now with that in mind, it’s important to note that none of the above is actually priced into either BHP or Rio. This is despite the fact that not only did these bad outcomes not occur, but the probability of them occurring next year looks slim at this point. Sure, both stocks have recovered from lows reached in June – when fears were greatest.  Rio is up 26% since then, and BHP is 14% higher.  But they’re both still down from their 2013 peaks in February – by a good 8-10%.

The lack of momentum shows that both stocks are still pricing in bad news and they have failed to fully bounce back when all the pessimistic scenarios proved wrong. Just take a look at their valuations – on a trailing basis BHP and Rio are on an earnings multiple of about 14.9 and 13.4 respectively. I’ll admit that this doesn’t appear to reflect great value or anything, although they’re certainly not rich. Yet, when you factor in earnings expectations for 2014 and 2015, both stocks are cheap. Rio is travelling around 10 or 11 times earnings and BHP is 13 times earnings. In both cases they are at the lower end of the price earnings range for the last five years or so, and well below average.

This is all the more remarkable when you think of the tendency or willingness of investors to price other sectors at a premium – often a significant premium (high earnings multiples). This is the case even where there is a weak macro story underneath them; in particular I’m thinking about some of our retailers here.

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This is all the more curious when you think about our position in the cycle and the unfolding economic discussion. 

Sentiment in Australia is getting worse it seems and, if press reports are right, the government is going to make some significant downward revisions to growth on Tuesday in its economic review. At the same time, everyone else is getting more bullish on global growth. To my mind that, at the very least, demands a re-rating away from some of our domestic growth stocks toward those with a global growth story attached – BHP and Rio. I appreciate the fact that not everyone will share my view on the global expansion; there is still a lot of doubt out there. But that’s my point – that doubt and more is already priced in, and these low earnings multiples are I think too low.

At current levels then, you don’t actually need my view of the world to pan out – you don’t need things to pick up. No change is good enough! The status quo will suffice and if that’s all we get, these stocks are still cheap.  

Outside of that there are numerous other reason why you don’t even need to be bullish on the global outlook – you don’t need to be bullish on anything and these stocks should continue to lift, because of:

• The aggressive capex cost cutting being undertaken by both firms.
• The strong lifts in production which are expected next year – and these are predicated on a fairly weak global economy.
• Earnings per share growth over 2014 will be supported by a significant base effect. That is, EPS growth for both firms in 2012-13 was very weak, driven down by a combination of high impairment charges and allowances for depreciation. An earnings upswing will result, simply from these factors dropping out.

If, on the other hand, global growth does end up being its strongest since 2010, then both BHP and Rio are well placed to see their earnings surge. That from a combination of capex cost cutting, EPS base effect and a lift in actual revenues from demand. Indeed, from a demand perspective, I concur with the view expressed in Tim’s note that the super cycle isn’t over – it’s just paused.

The bottom line is that the confluence of factors that acted to dampen BHP and Rio’s share prices in 2013 no longer exist. Therefore, and in the absence of those, I don’t think poor sentiment on these stocks can be sensibly maintained in an otherwise ‘expensive’ market.