When you think about what the future holds for resource stocks, what comes to mind? Chances are words like ‘value’ don’t figure into your line of thinking.
The ASX200 lost 12.3% of its value since hitting a peak in April. Resource stocks bore the brunt of the selloffs. BHP Billiton [ASX:BHP] is down $8 a share since May, to $25.04. Rio Tinto [ASX:RIO] is in the same boat, down $8 to $38.19 a share. Outside of the big two blue chip mining stocks, the story remains the same.
Yet you might be underestimating the potential worth of resource stocks in the years ahead. At least that’s the conclusion investment bank UBS reached in a recent market study.
It reckons the markets are much too pessimistic about resource stocks. And maybe they have good reason for this. As the bank acknowledges:
‘[Return on equities] have fallen away with the collapse in commodity prices and the market is clearly questioning whether ROEs can recover to the cost of capital’.
But in the wake of this resource led rout on the ASX, UBS went looking for value. What it found suggests the resource sector offers plenty of upside in the years ahead.
What did UBS screen for?
It looked at stocks that met a variety of conditions. They represented both absolute and relative value for investors. And it screened for projected and normalised value too. It did this by assessing the price to book ratio, and price to earnings ratio relative to stock history. Keep in mind that this screen aimed to measure a stock’s growth potential too.
What UBS found might come as a surprise to you. Its screen showed resource stocks ranking highly among the 10 cheapest stocks. UBS notes:
‘As a general statement it was interest to see resource and resource-related stocks heavily represented in our cheapest 10 stocks on a price to book basis. This is interesting in the context of recent private equity activity in the sector’.
Which resource stocks ranked highly end of the list?
Santos [ASX:STO], BlueScope Steel [ASX:TES], and BHP’s spinoff South32 [ASX:S32] were the top three by price to book ratio. Origin [ASX:ORG] and Fortescue [ASX:FMG] also screened well by this measure.
Yet this was only one test. Other tests, like those ranking price-earnings relative to history, provided different results. Outside of Alumina [ASX:AWC], no other resource stock ranked highly. However, bank stocks like ANZ [ASX:ANZ] and retailers JB Hi-Fi [ASX:JBH] were among the best performers in this category.
UBS’ final screen accounted for the impact of cyclical issues, looking ahead to 2018.
On this front, resource stocks came out on top again. Santos, South32 were the top two, alongside Iluka Resource [ASX:ILU]. Alumina and Origin rounded out the top six.
But as UBS admit, these screens might be vulnerable to optimistic commodity price rebounds.
And, in the case of iron ore in particular, the outlook on prices remains poor.
Goldman wades in on iron ore and oil
Goldman Sachs shares a particularly grim outlook on iron ore. This isn’t great news for the likes of South32.
The bank has maintained a negative outlook for the long-term future of prices for some time.
Iron ore prices have fluctuated between US$40 and US$60 since the start of the year. Despite the rebound to US$63 a tonne, prices are still down 20% on last year.
Goldman sticks by its earlier estimate that iron ore could fall as low as US$49 by the end of the year. By mid-2016, it estimates iron ore prices hitting a low of US$46 a tonne.
For Santos and BlueScope, Goldman doesn’t have better news on the future of oil prices.
Just last month the bank said there was a 50% chance crude would drop to $20 a barrel by next year. Not only that, but it reckons that oil glut could keep prices low for the next 15 years. Which makes UBS’ market assessment something of a mixed bag.
If you agree commodity prices will rebound, its screen might make investors reconsider resource stocks. If not, then the outlook for the sector remains bleak.
Contributor, Markets and Money
PS: The Aussie share market has lost $90 billion of value since June.
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Vern is the award-winning Founder of the Gowdie Family Wealth and The Gowdie Letter advisory services. He’s ranked as one of Australia’s Top 50 financial planners.
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