Sunday, 2 June 2013

Digging for riches

Unless you've been living under a rock, I presume that you're already aware of the 'slowdown' in the resources sector since late last year, as the media calls it. Some experts are labelling it the end of the commodity boom or even the end of Australia's economy as we know it, while others offer a more optimistic outlook. Almost every stock related to iron ore, gold, coal, or resources in general, has taken a beating (I'm talking about the share price). But as any true investor knows, it pays to look at the businesses themselves, not the share price. So, if you'll excuse the pun, let's dig a little deeper into the issue.

Watching events in this area unfold, I think it's safe to say there definitely has been a deterioration in the fundamentals of most mining and mining services companies. Combing through the wreckage, I've seen countless earnings downgrades and not a single upgrade in this space. To give you an idea of what these companies are complaining about, Roger Montgomery has conveniently compiled some snippets here.

Forge Group (FGE), the first stock I bought in my portfolio, was sold after their half yearly report in February. Forge continued to rack up stellar results with NPAT up 60% compared to the previous half and an even larger cash balance, leading many investors to believe that FGE could really defy gravity. However, I saw differently - if you take a close look at its order book, you'll see that the lower margin 'power' subsidiary is now far more important to future work than its traditional mining services business, which had struggled to secure new contracts. Hence, despite the appearance of a stable order book, I believe the slowdown had indeed hit FGE months ago and earnings will consequently decline if the power division is the main revenue driver. It seems Clough (another mining services business ASX:CLO), who held 36% of the company, see something similar coming as they sold their entire holding in March at a price just under me. 

Elsewhere, other high quality mining services businesses have been sold off, even the venerable Monadelphous has fallen 44% from its peak in February over a less favourable outlook. Each day I look at the stocks that are selling at one year lows, and surprise surprise, resources stocks dominate the list. In any environment where people only seeing doom and gloom, I'm certainly more interested in buying stocks - as Warren Buffett said, 'A simple rule dictates my buying: Be fearful when others are greedy, and be greedy when others are fearful.' However, caution must be taken with this contrarian attitude as sometimes the crowd does actually get it right. 

I'm no economist, but it seems fair to say that commodity prices are a pretty big deal when it comes to these businesses, and in turn, these prices depend on the demand from countries like China as well as the supply side. If you believe China is a bubble and is set to pop, resources stocks in general probably won't be a good idea, even at these low prices. If you believe China is going to have a 'soft landing' and commodity prices will head higher, then there is a fortune to be made for the brave. Personally, I don't place much faith in the notoriously inaccurate forecasts of economists and have little conviction one way or the other on commodity prices, so I'd prefer to find opportunities that are so ridiculously cheap that there is a good chance I'll make money even if the worst comes to pass. I hope my recent purchase of DSB fits that description, but there are no guarantees for an underground coal mining services company.

At the moment, I'm largely waiting for cheaper prices or signs that the sector is rebounding. Nevertheless there are some interesting stocks I've had a look at, such as BYL, SCD and DCG. While I've decided to pass for now, throwing around a few names for investigation may be of interest to the reader. 

Well, instead of sitting on a sizeable pile of cash, I'd better get back to work in digging up my next gem. 

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