Cheap resources stocks a tempting target for the brave

IT'S a tempting time for investors peering into the resources lolly shop with pocket money in hand.

Bags of BHP Billiton shares haven't been this cheap for three years.

A scoop of Rio Tinto the stock that traded above $120 per share before the global financial crisis and was still testing $89 last year will set you back less than $56 today.

There's plenty of others begging to be included in the party mix Woodside, Fortescue, Atlas, Newcrest Mining all going at prices 15 to 30 per cent less than they were just three months ago.

The major causes are well known: European worries have escalated, Chinese data has slipped a tad, commodity prices have receded and public sentiment from the big miners has changed notably towards the cautious.

That has added up to a sudden lack of love for resources stocks, which some experts now believe has been overdone.

Analysts at Deutsche Bank this week ran a pessimistic macroeconomic scenario through their models and found that some resources stocks were not only trading below their current fair value, but were trading below what their fair market price would be in a significantly weaker economic environment.

Assuming commodity prices fall well below current levels for a sustained period, and growth projects don't go ahead, Deutsche found the recent market punishment had been particularly harsh on Rio Tinto, BHP and uranium miner Paladin Energy.

Deutsche found Rio shares were today worth 30 per cent less than net present value would be under the pessimistic scenario, while BHP's current share price was 13 per cent less.

"Although there is likely one or two quarters of earnings downgrades ahead, value has emerged and some stocks do appear oversold," the report said.

But it wasn't all one-way traffic: Deutsche found gold play Newcrest Mining and iron ore miner Atlas Iron were vulnerable should the pessimistic scenario play out.

For those who let price-to-earnings ratios guide their investments, there's plenty to get excited about at the moment. BHP, for example, was carrying a PE ratio above 10 barely three months ago, but is rated at 9.6 by multiple investment banks now.

Based on the recent changes to PE ratios, Goldman Sachs this week ranked Fortescue and OneSteel (which is increasingly focused on exporting iron ore) among the cheapest resources stocks right now.

The analysts at Macquarie who have a bullish view on iron ore's future also like Fortescue. Macquarie is predicting a strong rebound in iron ore prices during the second half of 2012 and believe Fortescue's large, near-term expansion program is best placed to take advantage.

But while the sector may be looking cheap, there's an entirely different debate over whether now is the ideal time to buy.

Many resources analysts say PE ratios are far from the best way to measure the particular quirks of the mining sector.

"I haven't had a conversation with an investor about PE for about three years," said one analyst this week.

"It's about the outlook in China, commodity prices, the company's growth, sustainability of the cycle, the capital management: it's those factors that drive these resources companies rather than PE."

And none of those factors are creating much optimism at the moment.

Tim Schroeders from Pengana Capital says net present value is a better guide to the resources scene.

"A more simplistic approach is that it's very difficult for the share prices of these companies to go up while commodity prices are still falling," he said.

"It's very much driven by what the commodity prices are doing and until you see a stabilisation of those prices you are unlikely to see share prices move upwards."

Most pundits believe the current commodity price slide has further to run particularly in iron ore meaning investors may want to keep their hands in pockets for some time yet.

The floor in the iron ore price set by the production costs of marginal iron ore producers inside China is believed to be somewhere between $US110 per tonne and $US120 per tonne.

That theory gained further credibility when last September's spectacular price slide finally turned around at $US116 per tonne.

With the benchmark iron ore price still edging close to $US130 per tonne, several analysts said it was reasonable to expect the falls to continue.

Stability in the oil price a crucial reference for stocks such as Woodside and Santos also seems unlikely in the short term. The American benchmark oil price West Texas Intermediate was this week at its lowest price for seven months, and the future is clouded by decisions over whether to extend sanctions banning exports from Iran.

Mr Schroeders said in times like these there is no point trying make a hero of yourself.

"As a rule you are better off waiting for greater certainty than trying to pick the bottom," he said.

"You are better off waiting for confirmation that an equilibrium has been reached and there is a higher degree of earnings certainty, and then step in at that stage, rather than trying to be brave and pick the bottom, when you might just be riding unprofitable trades that you need to extinguish at a later date."