Just because shares are cheap does not mean it is time to buy, writes Peter Ker.
IT'S A tempting time for investors peering into the resources lolly shop, with pocket money in hand.
Bags of BHP Billiton shares have not been as cheap for three years. A scoop of Rio Tinto - the stock that traded above $120 a share before the financial crisis and was still testing $89 last year - will set you back less than $56 today.
There are plenty more 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 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 macro-economic 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 present levels for a sustained period, and growth projects do not 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 worth 30 per cent less today than net present value would be under the pessimistic scenario, while BHP's 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 was not 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 is plenty to get excited about at the moment.
BHP, for example, was carrying a P/E 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 the year and believe Fortescue's large, near-term expansion program is best placed to take advantage.
But while the sector may be looking cheap, there is an entirely different debate over whether now is the ideal time to buy.
Many resources analysts say P/E 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 P/E 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 P/E." 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 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 in China - is believed to be somewhere between $US110 a tonne and $US120 a tonne.
That theory gained further credibility when last September's spectacular price slide finally turned around at $US116 a tonne.
With the benchmark iron ore price still edging close to $US130 a tonne, several analysts said it was reasonable to expect the falls to continue.
Stability in the oil price - a crucial reference for stocks like Woodside and Santos - also seems unlikely in the short term.
The American benchmark oil price - West Texas Intermediate - was at its lowest price this week for seven months, and the future is clouded by decisions over whether to extend sanctions banning exports from Iran.
Mr Schroeders said that 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."
Frequently Asked Questions about this Article…
Are BHP and Rio Tinto considered cheap right now for investors?
The article says both look much cheaper than a few months or years ago — BHP shares hadn’t been this cheap for three years and Rio Tinto was trading well below its pre‑crisis highs. However, analysts at Deutsche Bank also found some of that weakness may be justified under a pessimistic economic scenario (they estimated Rio could be worth about 30% less and BHP about 13% less under that stress case). In short: prices look low, but value depends on commodity outlook and economic risks.
Should I buy mining stocks just because their P/E ratios look low?
Many resources analysts in the article warn that P/E ratios aren’t the best guide for mining stocks. Mining valuations are driven more by commodity prices, China demand, project growth, cycle sustainability and capital management. The article notes experts prefer measures like net present value and suggest waiting for earnings and commodity stability before relying on low P/Es to make a buy decision.
Which resources stocks did analysts say look particularly cheap right now?
Goldman Sachs ranked Fortescue and OneSteel among the cheapest resources stocks based on recent P/E moves, and BHP’s P/E had fallen to around 9.6 according to several banks. Macquarie also likes Fortescue given its near‑term expansion. Remember the article also highlights that ‘cheap’ can still be vulnerable if commodity prices fall further.
What key factors should everyday investors watch before buying resources or mining shares?
The article points to several things to watch: commodity price trends (iron ore and oil), Chinese growth and data, European economic worries, company growth projects and capital management, and the likelihood of earnings downgrades. Analysts recommend waiting for a stabilisation in commodity prices and greater earnings certainty before increasing exposure.
Is the iron ore price likely to keep falling and what is the expected floor?
Pundits quoted in the article believe the iron ore slide may have further to run. The floor is thought to be set by Chinese marginal producers’ costs—estimated around US$110–US$120 a tonne. The article notes the benchmark did turn around previously near US$116, while it was nearer US$130 at the time of reporting, so continued downside was considered reasonable by several analysts.
How important is oil price stability for companies like Woodside and Santos?
Very important. The article says oil price stability is a crucial reference for stocks such as Woodside and Santos. With US benchmark West Texas Intermediate at a seven‑month low and uncertainty around Iran export sanctions, short‑term oil price stability looked unlikely — which increases risk for oil and gas producers.
Which mining companies were flagged as vulnerable if a pessimistic economic scenario plays out?
Deutsche Bank’s analysis suggested some names could be vulnerable in a sustained weak environment. The article specifically highlights that Rio Tinto, BHP and uranium miner Paladin Energy were hit hard by the market. It also notes Newcrest Mining and iron ore miner Atlas Iron could be vulnerable if the pessimistic scenario materialises.
When do analysts recommend stepping into oversold resources stocks?
Analysts in the article advise against trying to ‘pick the bottom.’ Tim Schroeders of Pengana and others recommend waiting for confirmation that commodity prices and earnings have stabilised and for a higher degree of earnings certainty. The takeaway: wait for greater certainty and an equilibrium in prices rather than buying solely because shares look cheap.
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