The investment adage “buy when there is blood on the streets” is much easier in theory than in practice. Extreme pessimism and high volatily can dissuade even hardened contrarians from capitalising on market irrationality and panic selling.
Consider small resource stocks. Many have fallen 80 per cent from their peak share price. Fears of stalling global growth, falling commodity prices, and tough capital-raising conditions have belted small miners.
Unable to raise equity capital, many junior miners could run out of cash in 2015. Some will operate in “care and maintenance” mode as they try to survive; others will sell exploration tenements to raise cash; and mergers and acquisitions will feature.
Some contrarians I know believe now is the best time in a decade to buy small resource stocks – provided you can withstand high volatility. They see opportunities to buy better-quality junior miners at a fraction of previous valuations, and make big gains from a recovery.
Their logic revolves around local and global fund managers rotating out of overpriced industrial and financial stocks in the first quarter of 2015, and into beaten-up resource stocks. With small resource stocks on their knees, their downside risk is reduced.
I’m not as bullish. This column has mostly avoided resource stocks in the past two years for a simple reason: history shows investors underestimate the strength of commodity-price booms and busts. This commodity-price downturn still has further to run.
The question, of course, is how much of the negative outlook is already priced into junior mining stocks. And which have the balance sheet and exploration portfolio to weather the downturn, and capitalise on firesale prices in the next few quarters.
The irony is that many junior mining companies, having arguably raised too much capital in 2009 and 2010, are much closer to their key milestones; stgeloping an ore reserve or getting into production. Some great value will emerge when the final washout comes.
My main hesitation is the absence so far of a massive capitulation that usually marks the end of resource downturns. Anecdotally, insolvency rates among junior mining companies are rising, and there is talk of higher demand for reverse takeovers or “backdoor listings”.
But a bust of this magnitude should lead to a wave of insolvencies and industry consolidation – dozens or even hundreds of micro-cap miners running out of cash, being forced to merge, or sell assets at firesale prices – and more worthless assets because they are no longer viable at lower commodity prices.
If commodity prices keep falling, this capitulation could occur in the first half of 2015, and plant the seeds for the next bull market in resource stocks, which at the start will happen slowly and by stealth, catching investors by surprise – if market history repeats.
However, it is probably still too early to buy small resource stocks, although value is rapidly emerging. Portfolio investors should keep a watching brief on better-quality small- and mid-cap mining companies over the next few months in anticipation of better value.
Stick to a few key rules: focus on stocks in production, or with enough capital to get to production. Avoid those that require huge slabs of new capital, via dilutive equity raisings, to stgelop their projects. Such money will be even harder to find next year.
When choosing exploration stocks, focus on those trading near their cash backing. It is not always a surefire bet: some mining stocks can trade below their cash backing if the market believes the cash will quickly deplete, or if the exploration assets are worth more to the company dead than alive, given the expense of maintaining them.
Caveats asides, some interesting mining ideas are emerging. Iron ore producer Mt Gibson Iron has been clobbered from more than $2 in late 2010 to 50 cents. Like other small-and mid-cap iron stocks, Mt Gibson has tracked the tumbling iron ore price.
Its September quarterly, released this week, showed cash and term deposits of $465 million, which equates to 43 cents a share. Although slightly less than the market expected, Mt Gibson’s cash is getting close to its $551 million market capitalisation.
Mt Gibson has the balance-sheet strength to weather lower iron ore prices, keep paying dividends, and acquire weakened competitors when the time is right. The company looks far better placed to handle this slump than after the 2008 Global Financial Crisis.
Its September-quarter revenue of $117 million was lower than analyst forecasts. The falling iron ore price and an unfavourable product mix hurt revenue. It remains on track to meet guidance to ship 6.6-7 million tonnes of iron ore in FY15.
Mt Gibson is not for conservative investors. It is not in the lowest quartile for production costs, and has reasonably short mine life (about six years) for its reserves. Also, the odds favour lower iron ore prices in the next 12 months.
But 86 per cent of Mt Gibson’s share price is now supported by cash; it should produce up to 7 million tonnes of iron ore next year (depending on the price); and it does not need to raise capital. These characteristics stand out in such a high-risk, uncertain sector.
Macquarie Equities Research has an outperform recommendation and a 12-month share-price target of 65 cents, implying a 12-month total shareholder return of 40 per cent (including dividends; the price was 49 cents when Macquarie wrote about Mt Gibson this week).
Morningstar has a hold recommendation and a 60-cent valuation. That looks about right, but further price weakness in the lead-up to Christmas could create a better buying opportunity in Mt Gibson for experienced investors who are comfortable with higher risk.
Chartists will not Mt Gibson is right previous price support in early 2013.
Tony Featherstone is a former managing editor of BRW and Shares magazines. The column does not imply any stock recommendations. Readers should do further research of their own or talk to their financial adviser before acting on themes in this article. All prices and analysis October 16, 2014.