South32 and the neon green
Recommendation
There are good reasons for optimism at South32. Recovering steel prices have helped lift manganese, metallurgical coal and nickel prices while a surge in aluminium prices promises riches ahead.
Supporting higher commodities has been surprisingly strong global growth and a remarkable appetite for risky assets around the world.
Key Points
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Looks superficially cheap ...
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... but it's cyclical
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Fully priced
This will all mean sensational profits for the miner which is already buying back shares aggressively and will likely pay a fat dividend this year and next. With a cash balance of almost US$3bn and over US$2bn in free cash flow expected, the surging share price would appear to be well deserved.
That is exactly why we should now sell.
We bought South32 because it was unloved and under-earning. It is now neither maligned nor profitless.
In fact, profits have soared, so high traditional valuation metrics look outright cheap: South32 trades on a price-earnings ratio of 11 and an enterprise value to earnings before interest, tax, depreciation and amortisation multiple of just 5. In most cases, this would be reason to buy, not sell.
Cyclical business
Yet this is a cyclical business. The time to buy is when profits are miserly and enthusiasm spent. Today, profits are bountiful and the disposition sunny.
South32 holds decent quality assets that should earn higher than average returns over the cycle. The share price, however, trading at 1.5 times net tangible asset value, implies the market is already pricing in rather healthy returns. That may last a bit longer but it won't last forever.
Miners tend to get cheaper than anyone expects and ultimately get dearer than anyone imagines. We've already seen extreme cheapness and may yet see higher prices but, the higher prices get, the more risk climbs. Today, the balance between risk and reward is no longer attractive.
Although South32 remains a decent quality miner with better than average assets and outstanding capital allocation, it is fully priced. Time to SELL.
Note: The Intelligent Investor Equity Growth and Equity Income portfolios own shares in South32. You can find out about investing directly in Intelligent Investor and InvestSMART portfolios by clicking here.