Resources: a post-mortem
The instinct of value investors is to hunt in areas that most are ignoring - to be greedy when others are fearful. Many times, this instinct serves us well.
The instinct of value investors is to hunt in areas that most are ignoring - to be greedy when others are fearful. Many times, this instinct serves us well.Both commodity and equity prices have fallen dramatically this year. Base metals, gold, agriculture, coal and fertiliser prices all tell the same story: the resources boom is over.With stock prices now falling, is it time to get greedy?Not quite. Although prices of both commodities and equities have fallen, they remain historically high.Moreover, Mr Market's main concerns today - Europe and China - could get a lot worse. Today's stock prices still anticipate considerable growth.Avoid mining servicesSome parts of the resources sector are less attractive than others. In particular, mining services stocks are to be avoided. These are almost universally terrible businesses. With no barriers to entry, high cyclicality and wage inflation eroding profits, the boom masks how risky the sector is.Take Monadelphous, for example. The share price has had an incredible run, rising from less than $2 in 2004 to more than $20 today. Profits have rocketed earnings per share have grown from 11? in 2004 to $1.09 last year. It's tempting to credit the company with achieving stupendous success.Monadelphous is a good business. It's the pick of the sector and deserves kudos for performance. Profits, however, have been driven by record levels of mining investment, not organic growth. This is a cyclical business masquerading as a growth stock.Investors have fallen for the ruse - it currently trades on a price-to-earnings (PER) ratio of more than 20. Should mining projects be cancelled - and make no mistake, that will happen if commodity prices fall - growth will evaporate.This will mean not only falling profits, but lower PERs as well - a double whammy that will ensure the stock falls swift and far. And that's the best in the sector.Lower-quality peers would be hit even harder. Those that have taken on debt would face a mortal threat.Base metalsBase metals stocks should, at some stage, yield opportunity. We estimate that zinc and nickel prices are already close to the marginal cost of production. That usually arouses interest, but not this time. Global stockpiles are large, so low prices can be sustained for some time.Several miners have reported cash losses Kagara Mining has already gone bust. Prices will recover as losses mount and production is cut, so now is the time to start identifying investment candidates, such as Independence Group and Western Areas, which might be buying opportunities if their respective share prices fall another 20 per cent.CoalCoal has gone from being hot to cursed, due to American gas. North American gas prices have fallen from more than $10 a gigajoule in 2006 to $2 a gigajoule today, allowing gas to compete with coal as a fuel source for American industry.As this trend continues, there is concern that the coal that once went to power America will ultimately be sold in Asia, lowering prices.This is already happening: US coal volumes into Asia are at 20-year highs. A significant freight cost is the only protection local miners have against an even greater flood of supply. Australian coal mining profits are at the mercy of global shipping rates.Stock prices are starting to reflect this risk. The hyper-valuations of just a few years ago have been savaged. The two highest-quality independent coal miners, Whitehaven Coal and New Hope Corporation, have seen share price falls of more than 30 per cent each in the past 12 months. Both companies are now on our radar.GoldAlthough the commodities rout has not spared gold, we remain far more upbeat on the sector. Gold is a currency rather than a commodity.With gold equities treated far harsher than the yellow metal itself, now is the time to pick up cheap speculative gold miners such as Silver Lake and Kingsrose Mining, but keep them to a small proportion of your portfolio, say 1 per cent to 2 per cent each.Big minersThe large miners still lack broad appeal despite the price falls. The Chinese economy has slowed slightly, but is still growing at a relatively swift pace.Should the structural factors we've sweated on presage much lower growth rates in China, savage share-price falls would follow.The giants of the industry - BHP Billiton and Rio Tinto - might become attractive in such a scenario. Low expectations are starting to be reflected in their valuations and contrarian instincts are starting to stir.Nathan Bell is the research director at Intelligent Investor, intelligentinvestor.com.au. This article contains general investment advice only (under AFSL 282288).