Why the Big Resource Stocks Are Not Yet a Buy

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It’s a particularly tricky time for Aussie investors.

You’ve got one part of the market — the financials — looking expensive and vulnerable from regulatory risk and a weak economy. On the other hand you’ve got another important part of the market — resources — in the midst of the worst bear market in decades.

Let’s take a look at the financial sector first. Earlier this week, the banking regulator APRA announced higher capital requirements for the big banks. It’s an attempt to level the playing field between the majors and the second tier banks, like the Bank of Queensland [ASX:BOQ].

Up until now, the big four banks and Macquarie have made their own rules up when it comes to capital requirements. Seriously. They’ve told APRA how much capital they need to set aside for each loan they write. This has allowed them to be more competitive and more profitable than the lower tier banks.

For example, in 2015, the Commonwealth Bank [ASX:CBA] will generate a return on equity (ROE) of around 18.1%. The BOQ will manage just 10.5%. Not all of the variance is due to differing capital requirements, but you get the picture.

In case you’re wondering, ‘capital requirements’ refer to the amount of capital a bank needs to set aside for each loan written. This acts as a safety buffer in the event that some of the loans go bad.

It’s not much of a safety buffer though. It amounts to a few cents in the dollar. But after 24 years of uninterrupted economic expansion, even the regulators think the banks are safe.

The recent changes will make them safer. But let’s face it, it’s a low starting point.

The upshot of this is that it should make the major banks, over time, less profitable. When you hold more capital against loans, the return on that capital falls. And usually, a declining return on capital means a declining share price.

So for the banks, which make up a major part of the Aussie market, you’re looking at lower profitability and pressure on near record high share prices. It’s pretty clear — to me at least — that you’re not going to see anywhere near the amount of growth from the banking sector that you’ve seen over the past few years.

On the other side of the coin, there’s the resource sector. It’s a bit of a bloodbath out there right now. From iron ore to gold, stocks are getting beaten up left, right, and centre.

BHP Billiton [ASX:BHP] is a good proxy for what is going on in the commodity space right now. It’s a global miner of all the major commodities, with quality, long life assets. And it’s struggling big time. From The Australian today:

BHP Billiton is set to log its worst underlying net profit in a decade and worst reported profit in 12 years, with up to $US5 billion ($6.7bn) of writedowns and other charges, mainly on its US petroleum assets and the South32 ¬demerger, adding to the impact of sliding iron ore, oil, copper and coal prices.

BHP yesterday said $US2.1bn of exceptional items related to the South32 demerger would hit its 2014-15 bottom line, adding to $US2bn of after-tax impairments on its 2011 US shale acquisitions revealed last week and up to $US1bn of new charges that will hit its underlying full-year profit.

BHP’s share price is in all sorts too. As you can see in the chart below, it’s sitting just above major support around the $25 mark. If it cracks below here, you’re likely to see $22 pretty quickly, which is a pre-GFC support level.

Source: BigCharts

Click to enlarge


Is BHP good value at these levels? It doesn’t seem to be. Based on 2016 consensus analyst forecasts, the company trades on a price-to-earnings multiple of nearly 20 times. And ROE is expected to reach slightly less than 8%.

But you can’t really value resource stocks in traditional ways. Often value exists in these sorts of situations. That’s because the analysts covering the sector have become mega-bearish themselves. Their future commodity price forecasts are pessimistic and in such a scenario, future earnings will of course look weak. This in turn makes commodity stocks look expensive.

Where future earnings are inherently uncertain, the best way to assess a stock’s ‘investment worthiness’ is by keeping an eye on the charts. That is, stay away from a stock when it is in a downtrend and get interested when it is in an uptrend.

As you can see, BHP is in a downtrend. A nasty downtrend. I would rather buy BHP at $30 when there’s a higher probability that it’s on its way higher than buy at $25 when it’s going the other way. That’s because you simply don’t know if it’s going to $20, $15, or $10 per share.

That’s not to say you can’t make money in resource stocks right now. I recently recommended a copper producer, which is up over 12% despite the recent commodity wipe-out. And there’s a mining services company in the Sound Money. Sound Investments portfolio, which is up nearly 10% too.

I based these picks on a combination of strong balance sheets, good value, and a healthy chart outlook. That is, the stock must be in an uptrend before buying. You want to swim with the tide, not against it.

Buying BHP, or RIO for that matter, is akin to swimming against the tide. And given both companies have a large exposure to iron ore, which is in a nasty bear market itself, I can’t see the tide turning anytime soon.

Putting all this together, the outlook for Aussie investors is complex. One part of the market is in a nasty bear market while the other is in a maturing bull. There are plenty of options in between of course, but you have to do your homework.


Greg Canavan+,

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Greg Canavan
Greg Canavan is the Managing Editor of The Daily Reckoning and is the foremost authority for retail investors on value investing in Australia. He is a former head of Australasian Research for an Australian asset-management group and has been a regular guest on CNBC, Sky Business’s The Perrett Report and Lateline Business. Greg is also the editor of Crisis & Opportunity, an investment publication designed to help investors profit from companies and stocks that are undervalued on the market. To follow Greg's financial world view more closely you can subscribe to The Daily Reckoning for free here. If you’re already a Daily Reckoning subscriber, then we recommend you also join him on Google+. It's where he shares investment research, commentary and ideas that he can't always fit into his regular Daily Reckoning emails. For more on Greg go here.

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3 Comments on "Why the Big Resource Stocks Are Not Yet a Buy"

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slewie the pi-rat
slewie the pi-rat
1 year 3 months ago
slewie’s ‘FLATION Report ~for US Wednesday ~US Dollars only US Dollar INDEX 97.5; +0.2 BLOOMBERG COMMODITY INDEX 95.3; -0.9; [-0.94%] more Dollar-Commodity DEflation, today, and with Correlation, as the BCI makes another long-term [13 years, allegedly, and counting] low. the Giant Squid CI [GSCI] took out the 400 level, early, and decently hard, with a “close” for the front contract [Aug.] at 395.6. more technical bad news, for commodities, at least for now. i told you i was a bit restive, yesterday, about that weak BCI close, and why… Caterpillar Corp. reported, opining that there is a global depression, from… Read more »
slewie the pi-rat
slewie the pi-rat
1 year 3 months ago

here is the 1-year AUD/USD:
if one were to do the math, it would be ~-22% change, since a year ago, beginning 23 July, 2014.

slewie the pi-rat
slewie the pi-rat
1 year 3 months ago

here is the 1-year AUD/CNY:
here, the math comes out to ~-21%, beginning 24 July, 2014.

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