Good grounds for growth

Share portfolios that have done best in recent years have been those with exposure to Australia's booming mining sector.

Though analysts are not expecting the resources sector to produce the same outstanding returns in the medium term, there are some smaller companies that could deliver higher returns, albeit with more risks than the market giants. (See table opposite.)

For investors, the Australian resources sector is particularly top-heavy with the big five - BHP, Rio Tinto, Santos, Woodside and Newcrest - making up about two-thirds of the sharemarket's resources index.

The resources sector is a proxy for global economic growth, says the fund manager of the Pengana Global Resources Fund, Ric Ronge.

"We are going into a period of moderate-level [global] growth," he says. Costs are rising for mining companies as they seek to attract and retain skilled labour and the capital costs for starting new projects increase.

The higher Australian dollar, which makes Australian commodities more expensive to foreign buyers, is not helping, either.

Miners also face flat or soft commodities prices therefore, analysts say, the challenge for these companies is to grow profits by increasing volumes.

The key remains Chinese demand. The world's second-biggest economy, with almost a fifth of the world's population, has many decades of development ahead of it. But its economic expansion is slowing.

Chinese authorities have lowered their forecasts for annual GDP growth to 7.5 per cent. In the past, China has always exceeded its growth forecast and markets are expecting growth of more than 8 per cent. Nevertheless, that is down from the 9 per cents, 10 per cents and 11 per cents of recent years.

Other headwinds include global economic growth remaining sluggish, the European debt crisis dragging on and economic recovery in the US struggling to gain momentum.

Ronge favours companies that have lower costs and are well placed to grow volumes, given that growth from rising commodity prices is less likely.

BHP VERSUS RIO

For investors who want to add some resources stocks to their share portfolios, analysts are fairly evenly divided between BHP Billiton and Rio Tinto.

"BHP is much more diversified than Rio," says a senior resources analyst at Morningstar, Mark Taylor.

BHP has a petroleum division that has grown significantly with the company's shale gas acquisitions in the US, he says. More than 30 per cent of BHP's earnings is from oil and gas and about another third is from iron ore, with most of the rest from copper.

Rio is much more iron-ore concentrated, accounting for about 80 per cent of earnings. Taylor says $51 is "fair value" for BHP shares, which are trading about $35. "BHP is a standout compared to Rio because of its energy exposure," says the resources analyst at Fat Prophets, David Lennox.

Ronge, on the other hand, prefers Rio Tinto. Rio has good-quality assets in iron ore, copper and thermal coal. "It has repaired its balance sheet and, although it has been going through a bit of a soft patch with iron ore, is well positioned to supply iron ore to Asia," he says.

Ronge is critical of BHP's purchase last year of US shale-gas producer Petrohawk. He says BHP paid a "meaningful premium" to buy Petrohawk, which is facing a "soft environment" with US gas prices down.

The chief executive of Lincoln Indicators, Elio D'Amato, is expecting the prices of iron ore and coal to ease further as increased global supply comes online.

The floods in eastern Australia have slowed the supply a little in the past year. Nevertheless, prices are expected to stay well above historical levels, he says. "And given the billions that BHP and Rio are investing, they would tend to agree with that as well," he says.

Both BHP and Rio are in excellent financial health, D'Amato says.

But small investors are unlikely to hold both stocks to get their resources exposure and he favours Rio.

"Rio is engaged in more proven projects, where BHP has a little bit more 'blue sky'," D'Amato says. He is still comfortable with BHP as an investment proposition but says Rio has a better balance sheet and its shares are trading at a deeper discount to fair value.

Of the iron-ore stocks, D'Amato favours BC Iron. It's a small company that is working the Pilbara and has a joint venture with Fortescue Metals Group. Among the larger miners, D'Amato points to Iluka Resources, which mines mineral sands in Australia and the US. Some of the "rare earths", which have important industrial applications, are found in mineral sands.

"Iluka is a $7 billion company [by market capitalisation] that pays 4.4 per cent dividend yield, fully franked, which is expected to increase in the near future," D'Amato says.

That's good given many miners do not pay dividends. And of those that do, the cash dividend yield is usually 1 per cent or 2 per cent.

Iluka's share price has dipped because it has just paid the dividend, which provides a good opportunity for investors to acquire some likely long-term capital growth in their share portfolios as the company increases production, D'Amato says.

GOLD LOOKS GOOD

Lennox likes Newcrest, Australia's biggest listed gold producer. "We think the company's profile in terms of gold production looks very exciting over the medium to longer term," he says.

The only black mark against the company is that it should have "kicked the tyres" on Lihir before buying the smaller goldminer in 2010, Lennox says.

Last month, Newcrest revealed that electrical and mechanical problems had caused repeated shutdowns at the Lihir mine in Papua New Guinea and could cause a reduction in gold production.

"We would suggest that investors should have gold exposure as it provides exposure away from the commodities cycle," Lennox says.

Generally, the gold price moves in the opposite direction to commodities. Investors favour gold when the economic outlook turns gloomy, while commodities prices tend to dip.

Taylor also likes Newcrest. He says the shares have a fair value of $42, compared with the current price of about $32.

As well as being a good-quality gold company that is generating solid returns, it is "a bit of an insurance policy" if the other stocks in a portfolio are being hammered, Taylor says.

For investors prepared to accept the risks, Lennox likes junior gold explorer Gold Road Resources. It's prospecting for gold in a vast area of Western Australia and has produced some good drilling results - though has not yet produced any gold. The company is expecting to produce significant amounts of the resource but it is a risky and speculative play. Its share price is volatile. The company has a market capitalisation of only about $150 million.

D'Amato likes Silver Lake Resources, a goldminer that has a market capitalisation of about $800 million. Its earnings are expected to rise by more than 200 per cent when the company releases its full-year results in six months' time, D'Amato says. "Gold prices appear to be stabilising ... and we believe that gold prices will reside at these prices for quite a while," he says.

OIL AND GAS

Woodside, among the world's biggest producers of liquefied natural gas, is a favoured stock of many analysts.

It operates the huge North West Shelf Project off the north-west coast of Western Australia. It is developing and expanding other gas and LNG projects in seas off Australia.

"We like Woodside," Lennox says. It is a well-run company that is shipping LNG to south-east Asia and Japan, which are not blessed with natural resources, he says. Taylor also likes Woodside.

He says its shares have a fair value of $66, with the current price about $36. He says Woodside is riskier than BHP and Rio as it has more debt on its balance sheet and a higher proportion of its valuation reflects development projects not yet in production.

But the miner is "well in front" of other Australian oil and gas miners.

Taylor says growth in gas demand globally is outstripping all primary energy sources except coal.

Taylor also likes Origin Energy because it is an integrated energy company - it owns gas-fired electricity generators and retails electricity and gas. It is also a part-owner of an LNG project in Queensland, which is a big part of the growth plans for the company, Taylor says.

He says fair value of the shares is $17.80 they are trading about $14.

"Our preferred oil stock, far and away, is Oil Search," D'Amato says. It is a $9 billion stock. "The company has great exploration upside potential."

Gold as a hedge away from the commodities cycle

Not all analysts are keen on the resources sector. The editor of Sound Money. Sound Investments, Greg Canavan, says: "I am a bit cautious on the whole resources sector."

He thinks the picture for commodities is deteriorating but is being masked by the "blast of liquidity" at the moment, particularly from the European Central Bank. "It's giving the impression to investors that things are still quite healthy," he says.

Even though BHP Billiton and Rio Tinto are good companies, Canavan would not be recommending them.

"I don't think they are great buys at the moment," he says.

The mining services stocks, those companies that supply the mining sector, are a particular risk if the commodities cycle turns down. "They will get caught with all of this capital equipment and their revenues will get shot to pieces," he says.

Canavan favours gold. Although gold stocks are included in the resources sector because gold is dug from the ground, the underlying driver of the yellow metal's prices are different to the price drivers of "standard" commodities, he says.