Relying on investment maxims is a dangerous strategy, but a few enduring truths in the resource sector provide useful clues.
The first is that resource boom-and-busts are typically stronger and longer than the market expects. Investors continually underestimate commodity-price strength during the boom and miscalculate how far metals can fall during the bust.
The slightest commodity-price upturn has promoters calling the end of the bear market in resource shares, when a long march lower over several years is inevitable.
The second maxim is that the best time to buy resource stocks is when companies stop investing in projects, which constrains medium-term supply and supports an eventual price recovery. The worst time to invest in resource shares is often when projects are plentiful and a flood of new supply is about to enter the market.
The third maxim is that the peak of the bear market in resource stocks is usually marked by dozens of companies going bust. Unable to raise fresh equity and faced with dwindling cash, the junior explorers have to sell assets at fire-sale prices or be acquired.
These rough rules of thumb, only part of the investing equation, help explain why this column has mostly avoided small resource stocks over the past few years, apart from a positive view on gold, which has different price drivers than other commodities.
Only the biggest resource bull could argue a commodity boom of that magnitude could unwind within a few years, before reflating. My view, which holds today, is that commodity prices generally have further to fall as China’s economic growth underwhelms and Europe struggles.
Sharp falls in Chinese equities and iron ore prices this week underscore the unfolding bust in the resources sectors, which has further to run.
Moreover, companies were still investing in new resource projects, especially in sectors such as energy, where giant Liquefied Natural Gas projects take billions of dollars and years to build. The much-need supply adjustment was still ahead.
A wipe-out of junior exploration companies was also missing. Apart from a few high-profile collapses in mining services, a true bloodbath in speculative mining stocks was not evident. Heavy share-price falls are one thing; mining stocks that are virtually worthless is another.
Conditions are starting to look different.
Some base metals, such as nickel, are trading near 10-year lows, despite signs of improving fundamentals. They will fall further this year, but surely the bulk of the damage has been done in metals that were hit hardest before other commodities.
Investing in new mining projects is rapidly approaching a cliff. BIS Shrapnel late last year predicted a 40 per cent collapse in mining investment over the next four years. It may be a few years before the fall stabilises, but it’s hard to find too many resource companies pouring big dollars into greenfield exploration projects.
And a sharp consolidation of junior explorers is emerging as the volume of backdoor listings on ASX breaks records. One tech company after another is feasting on the carcass of a failed explorer, taking it over, and using its “shell” to list on ASX. It would not surprise to see up more than 50 junior explorers disappear from ASX in the next 12 months.
Although the key trends are heading in the right direction, at least for contrarian investors, a cautious approach to mining investing is warranted. This is no time for aggressive buying or to take a blanket approach. Selective buying in parts of the market that offer value is warranted, when the recent carnage in Chinese equities and commodities subsides.
Nickel is an example of an emerging contrarian idea The notoriously volatile base metal, thumped in the past few years, continues to fall, despite more brokers saying the end the nickel bear market is in sight. Nickel fell 5 per cent in a day in June after bad news from China and Greece. It is down almost 30 per cent year to date
UBS expects Chinese demand for nickel to drive the price to US$8 a pound in 2016, from about US$4.97. Falling nickel stockpiles will also support higher prices, says UBS.
In a research note this month, Macquarie Wealth Management said nickel fundamentals were starting to improve, despite recent price falls. It forecasts nickel to move to US$6.80-$7.70 a pound by the end of this year, but concedes there is significant forecasting error given the collapse in nickel prices this year. Macquarie also notes that valuations of the major nickel producers are factoring in a material recovery in prices.
Macquarie has outperform recommendations on Western Areas, Independence Group and Sirius, and 12-month price targets that suggest significant upside if met ($5 for Western Metals, $5.60 for Independence Group and $4.30 on Sirius Resources). It has a neutral recommendation on Panoramic Resources and an underperform recommendation on Mincor Resources.
Western Areas stands out from that list. The Western Australian-based nickel miner is expected to produce 25,500 tonnes of nickel concentrate this financial year and has cash costs below $2.36 a pound, putting it well inside the bottom half of the operating cost curve.
Thirteen of 16 brokers that follow the stock have a buy or strong buy recommendation, and three have a hold. A $4.69 median share-price target, based on consensus analyst estimates, compares with $2.69 this week.
I’m as bullish as the consensus forecast.. The advent of nickel pig iron, a lower-grade, cheaper alternative to pure nickel in stainless-steel production, is a headwind, and Western Areas has to show the market it can add to its mine life, at low risk and cost.
The acquisition of the Cosmos Nickel Complex in WA from Glencore in June, for $24.5 million in cash, was a good move. It has a significant resource base and comes with substantial production infrastructure. If all goes to plan, Western Areas should have a rising production profile in the next few years as the nickel price recovers.
Western Areas offers a reasonable margin of safety at the current price, but only experienced investors who can tolerate volatility should hold the stock. Nobody could rule out further nickel-price falls this year as the global economy wobbles, or more carnage in nickel stocks.
Contrarian investors with a long-term perspective might find current nickel weakness proves another enduring maxim – that the best time to buy is when everybody else is selling, although for nickel stocks and Western Areas in particular, it will pay to watch and wait for better value in the next few months.
Tony Featherstone is a former managing editor of BRW and Shares magazines. This column does not imply any stock recommendations or offer financial advice. Readers should do further research of their own or talk to their adviser before acting on themes in this article. All prices and analysis at July 8, 2015.