Small miners: The unexpected outperformers

One wouldn’t have guessed it but small resource stocks have been quietly outperforming at a time when the sharemarket is struggling for traction.

While the S&P/ASX 200 Index has been flat since the start of May, stocks in the ASX Small Resources Index have gained 3% on average.

If you excluded small gold miners, because the precious metal tends to march to a different beat to industrial metals, the gain doubles to around 6% over the same period.

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The outperformance is perhaps more surprising given that is comes against the backdrop of weaker hard commodity prices. The Commodity Research Bureau’s index of five metals (including copper) has slipped 1% in the past six weeks, while the iron ore price has slumped 12% to around its lowest level since September 2012.

The vexing question facing investors is whether the rebound is sustainable given that the sector has been nothing short of a dog’s breakfast over the past few years. I believe the tide is turning and the downtrend that has capped the ASX Small Resources Index for the past three years appears to have finally ended, as shown in the chart below.

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As I highlighted in December last year in the article Five small cap trends for 2014, the dark cloud hanging over the small end of the resources sector is expected to lift sometime this year as their valuation is getting hard to ignore. This is assuming that the global economy continues on its growth trajectory.

Indeed, the index seems to be forming a base in preparation of a new uptrend. The problem is that it needs a catalyst, and this won’t come from low valuations as the sector has been looking “cheap” for a while now.

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However, the hefty discount priced into small resource stocks has prompted bidders to emerge from the woodwork, and merger & acquisition (M&A) activity could well prove to be the elusive spark that lights the fire under the sector.

Takeover activity is heating up across the market, as highlighted by David Gilmour and Tom Elliott in last week’s article Takeover fever: six potential mega-deals, and the value of pending and completed M&A deals in the mining sector is still only a fraction of the overall market.

But it’s still hard to ignore the more than 310% increase in deal value to $2.6 billion for the current quarter compared to the same time last year. The deal pipeline for the three months to June also represents a near nine-fold surge over the March quarter.

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It is perhaps telling that the two most significant bids in the sector for the quarter have come from Chinese buyers. Copper-gold producer PanAust (PNA) received a $2.30 a share takeover offer from its 23% shareholder Guangdong Rising Assets Management, while coal and iron ore miner Aquila Resources (AQA) may have attracted a second suitor in the form of Mineral Resources (MIN).

Mineral Resources has bought around a 12% stake in the target for $3.75 a share. That represents a 10.3% premium to the original offer of $3.40 for Aquila, which came from joint bidders Baosteel Resources and Aurizon. Baosteel owns around 20% of Aquila.

It is far from certain if the bids will succeed, but it is clear that the Chinese are on the hunt for strategic assets and mining M&A is likely to make a comeback and support the downtrodden sector.

Aquila and PanAust are the best performing non-gold miners on the ASX Small Resources Index since the start of May, with the stocks jumping 44% and 36%, respectively. Nickel stocks like Western Areas (WSA) have also done well on the back of the bullish outlook for the metal, as highlighted in Tim Treadgold’s article in May, Nickel fills Palmer’s pockets.

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Junior copper producer Tiger Resources (TGS) is ranked sixth on the leader board. The miner is capitalising on its good performance by selling $US20 million of new shares and has locked in a $US25 million debt facility.

The capital raising news was announced on Thursday morning (June 12), the day after my article on Tiger Resources Tiger approaches dividend crossroad. I have adjusted my model to reflect the news and you can see a more detailed report here (Tiger tumbles on capital raising).

It’s hard to imagine things getting much worse for small miners barring some macro-economic shock. This means it is a good time for investors with little to no-exposure to the sector to start looking for value buys in anticipation of a good second half for risk assets.

However, investors will need to be very selective to pick the right stocks as junior resource companies will always to be a relatively high-risk proposition, even during the best of times.