Can the boom in mining shares be sustained? The experts give Barbara Drury their pick for investors.
The global market value of mining shares doubled in the 18 months to March on the back of insatiable demand from China, a global economic upturn and booming commodity prices.
Yet so much good news is bound to put cautious investors in a quandary. Has the mining sector hit paydirt with China's seemingly limitless demand for raw materials or is this El Dorado as elusive as all the others? In short, are mining shares a buy or a sell?
In a recent report on the global mining industry, PricewaterhouseCoopers found that net earnings of the global mining sector jumped 95 per cent last year on an 18 per cent increase in revenue. Capital expenditure and exploration both increased, while return on equity was a healthy 10.5 per cent, up from 6.7 per cent in 2002.
In a sudden rush of blood to the head, the report's authors declared: "Hopefully we are seeing the start of the first mining boom of the 21st century." Certainly the long-term big picture looks good.
Tim Goldsmith, a co-author of the PwC report, says China has a 20-30 year development plan, and other developing nations in the Asian region, including India, will continue to fuel demand.
On the supply side, mining exploration is at an all-time low. Despite major project developments, supply could be tight in the short-term - which is good for prices, provided there are no major moves in exchange rates.
Stephen Bartrop, of Fat Prophets Mining, says the strong sharemarket that ran through to February this year resulted in the resources sector being re-rated upwards by 30 per cent, but the waters have been choppier since then.
In recent months the market began to doubt the ongoing strength of Chinese economic growth and feared that the US might raise interest rates aggressively. In addition, the OECD leading indicator which charts industrial demand peaked early in the year and then dipped. This is usually a good indication that share prices have peaked.
However, Bartrop says there are signs that China will maintain healthy economic growth, albeit not at the exuberant levels of the past year, and be a major consumer of metals.
Economic recovery in the US and elsewhere has also helped run down stockpiles of metals and that should help underpin commodity prices. "The risk is not that commodity prices will fall but that they won't race ahead," says Bartrop, who believes commodity prices are sustainable at current levels. This, and the lower-than-expected exchange rate, should translate into robust earnings for many producers.
"The story has moved away from leveraging commodity prices," says Bartrop, who advises investors to look for companies increasing earnings, and cash flow not yet reflected in the share price. "The market will re-rate individual stories."
This appears to be happening with BHP Billiton. Most analysts now favour BHP ahead of Rio Tinto at the big end of the resources sector, although both are expected to benefit from the next leg up in the global economic cycle.
Quentin Timms, the senior mining analyst at Ord Minnett, says the biggest sharemarket gains are behind us but positive earnings from resources stocks mean P/E (price-to-earnings) ratios are shrinking as earnings increase.
BHP reported an excellent first half result and last week was trading at a P/E of
11.2, compared with Rio's 12.8. BHP was, however, trading at a slightly higher premium-to-NPV (net present value) of 23 per cent, against Rio's 18 per cent, indicating that the market believes BHP will outperform in the year ahead.
NPV refers to the current value of estimated future earnings. The ratio of the share price to NPV is then expressed as a premium or discount to NPV. A premium of about 50 per cent usually indicates a peak. Most analysts prefer to use NPV to assess mining stocks, rather than the more generic P/E ratio. Timms says NPV is a standard measure for resource projects where cash flow is volatile.
BHP's strength is in copper and aluminium, but it also has interests in oil and gas at a time when oil prices are historically high. By comparison, Rio's strength is in industrial minerals, which tend to run later in the economic cycle.
Ord Minnett has just replaced Rio with BHP in its core blue chip portfolio. Timms says BHP is more aggressively pursuing growth from its core divisions and the commissioning of new projects. It also has none of the recent operational issues Rio has faced, such as the pit wall collapse at Freeport and weather problems in WA.
Ords includes global gold heavyweight Newcrest Mining in its core growth portfolio. Timms says Newcrest has "an incredible growth profile in terms of production and earnings", and stands to be re-rated once it delivers on the giant Telfer project, due to start next month.
Only three Australian stocks - BHP, WMC Resources and Newcrest - were included in the top 30 global miners analysed by PwC. Of those, only Newcrest made it into the top five in terms of value.
At the smaller end of the market, Timms likes Centennial Coal for its strong long-term fundamentals and leverage to thermal coal export prices.
At the speculative end of the market, Bartrop likes copper hopeful Exco, zircon producer Gunson Resources (on the basis of strong demand for mineral sands) and Mithril, which is funded by BHP to locate potential projects and carry out exploration.
Fat prophets mining recommends
Blue chips: BHP
Small cap producers: CBH Resources, Straits Resources, Perilya, Sally Malay Mining, Mincor
Speculative plays: Exco, Gunson Resources, Michelago, Mithril
Source: Fat Prophets Mining
