Riding the resources rebound

Is the mining rebound for real? It looks like it: Take a quick glance at the chart below of the top performing stocks among the ASX 100 in the last three months and it is absolutely dominated by miners….and these are not small caps, these are global names based in Australia.

The most remarkable jump would have to be Fortescue (FMG), now a $10 billion stock which has doubled in price since the start of the year. Flanking the WA iron ore miner are a string of well-known names which in one way or another have come back from the edge…South32 (S32) up 70 per cent and Santos up 60 per cent.

Indeed it has to be said mining stocks have returned to portfolio planning and while safety-conscious investors have simply been buying the top two, BHP Billiton and Rio Tinto, there are potentially better returns available from digging a little deeper – but not too deep.

Of particular interest is a group which might be called “budding billionaires”: Companies which currently fall below $1 billion in market capitalisation, a value used by some institutions as a “materiality” test to see whether there is a market sufficiently deep to get in and out easily.

A step further down the value chain into the sub-$500 million range adds to the possibilities and introduces more options in the hottest commodities in the current cycle: gold, lithium, potash and graphite.

But, as you go lower in the value chain the risk factor increases with the bottom layers of the Australian stock exchange littered with thinly traded mining and oil stocks, which lack any market-depth and have little or no value.

Of the 37 listed stocks with a market capitalisation of less than $1m (and yes, there really are 37 listed stocks worth less than many houses) 24 are classified as miners, though with little cash and limited growth options they are best left to speculators because they fail every test of a genuine investment.

Looking from the top down, the list of ASX mining and oil stocks is dominated by BHP Billiton and Rio Tinto with their respective market values of $101bn and $79bn and ranking as third and fourth among the top 10 stocks.

The fact that BHP Billiton and Rio Tinto have reclaimed positions in the top five is a comment on their respective 38 per cent and 33 per cent share price rises over the past two months, a time which has seen bank stocks lose ground.

The two big miners have already slipped past two of the banks: National Australia Bank (5^th) and ANZ (6^th), and if the current trend of resources up and banks down continues they could move past Westpac (2^nd) and Commonwealth Bank (1^st), restoring resources to the leadership role of ASX-listed stocks.

Whether the share prices of the top two have got ahead of the prices of the underlying commodities which generate all of their profits is worrying some analysts which is why both leaders have fallen over the past few days.

After the top two there are only four other resource stocks out of 31 with a market value of more than $10bn:

Two stocks slip into the next bracket of between $5bn and $10bn in market capitalization: South32 (S32) ($8.9bn), and Santos (STO) ($8.2bn).

The choice of resource stocks widens in the next category of $1bn to $5bn with 12 in that range, including some that have outperformed the top two over the past three months as investors explore the potential for a widespread recovery in mining and oil earnings.

Alumina is already knocking on the door of the $5 billion-plus club with a value of $4bn, having enjoyed a 48 per cent price rise since early February when it was trading at $1 versus its current price of $1.48, an increase which puts it on track to hit its 12-month high of $1.81 set last June.

The next 11 stocks in the $1 billion-to-$5 billion range are: 

Companies with a market value of more than $1bn almost certainly offer a depth of market which should enable an investor to trade with confidence with selling as easy as buying which means avoiding being trapped in an illiquid stock.

The risk of illiquidity rises when you dip below the $1bn level but with just 175 (8.6 per cent) of the 2045 ASX-listed securities falling into the billion-plus club, you are competing in a remarkably thin market when it comes to choice.

Once you appreciate the relatively narrow range of stocks at the top of the market, and the uninviting world of ultra-small stocks struggling for survival at the bottom it is interesting to consider the middle ground where a large number of resource stocks are starting to benefit from improving commodity prices.

Nine mining and oil stocks fall into the budding billionaire category with market values of between $500 million and $1bn. 

Top of that list is Sandfire Resources with a market cap of $923m. Here is the full list:  

Some of those stocks are better known than others, but all are worthy of further research by private investors as they are certain to be on the radar screen of institutional investors, which use market capitalisation as a primary screening tool.

As you pass through the $500m market value point the level of interest at an institutional investor level fades rapidly and below $350m, you are outside the ASX300 and have entered territory banned by some fund managers – and dealing with stocks not researched by most investment banks.

But, for private investors uninhibited by strict materiality rules, there is a wide range of stocks with solid earnings records and growth potential, especially if commodity prices continue to improve after five grim years.

In the $250m to $500m range there are 11 mining and oil stocks with potential to improve

That list of stocks in the $250 million to $500 million includes names that will ring alarm bells for some investors. Paladin, for example, is struggling to post profits from its uranium assets, and Liquefied Natural Gas has highly-ambitious LNG plans in a tight market.

However, what a materiality test such as this demonstrates is that there are more stocks to choose from in the re-emerging resources sector than the usual suspects at the top of the food chain -- and the inedible small fry at the bottom.