Smart Investor: Acid Test, November 2010

Smart Investor, November 2010

Should you buy mining stocks?

1. Do you think the world is recovering? (Yes/No)

Many people feel that commodities, and so resource stocks, are a proxy for momentum in the world economy generally. When economies are humming, they consume a lot of oil, coal, iron and the rest. When they’re in recession, they don’t. A good global growth outlook is good for resource stocks.

2. Do you believe China is just going to keep growing? (Yes/No)

This is an easy one. The single biggest reason commodity prices continue to rise, and commodity stocks perform well, is because of the growing industrialisation of emerging markets, particularly China. As China urbanizes, as it builds cities and airports and railways, it needs more and more raw materials to do so: iron, copper, coal. The huge demand for these materials has been the main driver of share prices at BHP Billiton, Rio Tinto and the rest. Emerging market growth will continue to underpin performance at those companies.

3. Do you think the Resource Super Profits Tax in Australia is going to be modest and have little impact on stocks? (Yes/No)

The uncertainty over a mining tax has hit the performance of the resources sector in Australia. The key conclusion of CMC Markets’ most recent share trader insight survey was that discussions on the tax had dampened trader confidence towards materials stocks. To an extent, the outlook for resource stocks in this country depends on what form you think the tax will take and if you think it will go through.

4.Do you think stocks generally are undervalued? (Yes/No)

Stocks are still a long way below their all time highs, and that applies for resource stocks as well as any other. If you believe that these stocks will at some stage take out their highs, then that’s another consideration. If you think stocks are overvalued, though, given the economic headwinds the world is facing, then that’s an argument against.

5. Within that, do you think resource stocks are particularly undervalued? (Yes/No)

Many resource stocks have stagnated in the last few months, though the picture varies from place to place. Even those that have rallied generally are well below their highs. Consider Rio Tinto: It was trading at around A$75 at the time of writing, well up from its $30 low in late 2008 and from its $62 level in May this year. But it’s barely halfway back to the A$110 level it held in late 2007.

6. Do you expect more mergers and acquisitions like the BHP/Potash bid? (Yes/No)

If you answered yes, there’s still another consideration, because M&A tends to be good for shareholders of the target companies but not the bidders. If you believe that rich companies are going to start hoovering up smaller ones now that their balance sheets are in decent shape post-financial crisis, then the best way to make money is to buy the ones you think are going to be bought – firstly because a buyer will always offer a premium in order to buy, and secondly because that will hopefully trigger a bidding war. If you own shares in the bidder, though, a big acquisition tends to knock the share price at first – so if BHP keeps buying other assets, that will dampen performance in the short term.

7. Are you prepared to take a chance on companies with great upside but plenty of risk? (Yes/No)

This question applies not to heavyweights like BHP and Rio, whose sources of income are massively diversified and which are generally considered well run, but to smaller cap mining stocks, perhaps in the gold industry. At the lower end, no matter how much research you do on these companies, you are always taking something of a punt. The right discovery and they will go through the roof. But many exploration stocks will remain moribund indefinitely, as it’s expensive to go looking for resources even if you don’t end up finding any.

8. Do you want exposure to emerging markets without actually buying stocks based there? (Yes/No)

Companies like BHP and Rio are often purchased as proxies for emerging markets growth, because that’s where they derive a lot of their income from. A more extreme example would be Lihir Gold (now being merged with Newcrest Mining), which pre-merger derived most of its revenue from a gold mine in Papua New Guinea, and much of the remainder from Cote d’Ivoire. Most resource companies are not pure plays on emerging markets – it’s not as if you’d expect them to track, say, the Chinese stock market – but they are heavily exposed to trends there.

9. Do you have faith in emerging technology in areas like mining and drilling? (Yes/No)

Resources are going to get progressively harder to reach. We’ll have to dig deeper to get to the gold and drill in more hostile places to get to the oil. Unless you think resource stocks will be able to advance technology in order to do so, it’s probably not such a good idea to invest. And take a look at the Gulf of Mexico (or the BP share price) for a reminder of what can happen when things go wrong.

10. Do you believe resource companies can stay on the right side of environmental restrictions? (Yes/No)

Kevin Rudd didn’t get his emissions scheme through but there’s no question the overall trend in the world is to tighter regulation of emissions, and the resources sector is one area that is clearly going to be squeezed. Enlightened companies can still turn this into a business opportunity by staying ahead of their peers and being cleaner, or developing alternative energy. Others will struggle.

Mostly yes: You accept that resource stocks are well off their lows but think there’s plenty enough upside to justify investing now. Buy in.

Mostly no: There is too much uncertainty in the world economy, and resource stocks are just going to get hit more and more by regulation and restriction. Sell out.