Stand By for the Recession Rally in Resource Stocks: Take Two

‘KAPOW!’

‘SOCK!’

‘THWAPP!’

It’s like a Batman comic out there. Resource investors are getting belted from all sides.

I’d be dishonest if I said it was a laugh a minute.

First we had the once in 33-year fall that saw gold down by 14% in two days. Gold stocks fell off a cliff.

And then the resource sector tanked by 8%.

This all comes on the back of two long years of falls.

But there are always two sides to the same coin. So here’s the good news: The mining sector is now back to where it was in the GFC!

And last time it was down at these crisis levels…mining stocks started a 2.5-year bull market that saw the resource sector index gain 124.2%. Even better, smaller stocks gained far, far more than that.

Yet no one is thinking of the chances of that today. Fear is in control.

But like investing legend Buffett says, ‘Be greedy when others are fearful.’ And from where I’m standing, it will soon be a great time to be greedy…

Maybe it’s not your natural instinct to be bullish on mining stocks  right now.

And fair enough. After two years of falls, it’s not my natural instinct either.

But take a look at the chart…

Resource Sector — Back to Foundation Valuations


Source: bigcharts

I’ve circled where we are today.

You’ll see I’ve also circled the range it traded in during the GFC.

It’s hard to believe we’re back at GFC valuations again…but here we are…it’s incredible stuff.

Last time investors had the courage to go against the herd and buy at this level, they made life-changing amounts of money.

You have to take off your hat to those investors that stepped up the plate and went shopping for smashed up stocks in those darkest of days. The old saying goes ‘buy when there is blood on the streets’. But it’s easier said than done when it comes to it…when you’ve got real money on the line.

Back then they bought when the US economy was contracting at 4.6%, Chinese growth had collapsed from double digits to 6.2%, iron ore was at just $60/tonne, and copper was down to $3,000/tonne.

But don’t feel sorry for them. They saw the index gain 124%.

And the bravest investors who picked up the quality small-caps did FAR better than that.

In late 2008 you could have picked up copper explorer Sandfire Resources (ASX: SFR) for 6.5 cents. It had traded at $1.00 two years before that. So you would have been buying a cash starved small-cap that had already fallen 93%, and doing so during a full market capitulation.

Not the traditional investing approach, admittedly. But those that looked past the price, to the copper project the company was sitting on, went on to make 12,300% in the next two years as resource stocks recovered and Sandfire soared from 6 cents to $8.00 on its own merits.

It was the same story with Ampella (ASX: AMX), a gold explorer that was on hard times as the market crashed in late 2008. Gold had fallen 30% and gold stocks were particularly low. Cash was about to run out and the share price was down to just 6.5 cents. Bleak indeed. Yet some investors bought as they could get, and two years on, their Ampella stock had gained 5,800% to reach $3.42.

With the resource sector back at GFC valuations, it’s time to start positioning for these kinds of opportunities.

How to Pick Through the Market

If you can sort the wheat from the chaff — and pick the genuine contenders from the useless pretenders — then there is a massive opportunity brewing for you.

Possibly a better one…because the market is more on your side today than in 2008:

  • China’s growing at a chunky 7.7%, compared to 6.2%.
  • The US economy is at a modest growth rate of +1.7% but compare that to the -4.6% back in the GFC.
  • Iron ore is $140/tonne compared to $60 back then.
  • Copper is $7,000/tonnes compared to $3,000.

Cash will be essential.

By this I mean cash on the company’s balance sheet. Until they start producing, which can take years to achieve, mining juniors are money pits. With little cash on offer today, and management reluctant to raise cash at these levels, cash balances are running very low.

I ran the numbers. As of the December quarterly reports, the average small-cap was running on a song and a prayer. For the 415 resource stocks with a market cap under $20 million, the average cash balance is down to just $2.2 million, and is burning $0.9 million per quarter.

In other words, without a top up, the average sub 20 mil stock would run out of cash by September.

Bear in mind that was for the December quarter…soon we get the March quarterlies, and I’d expect the numbers to have got a lot worse.

So picking small-cap stocks to leverage a resource recovery won’t just mean picking the right projects, management and jurisdictions, but also looking very closely at the cash balance too. Ideally you want a stock that has a few years-worth of cash, though these are hard to find.

Of course, part of the reason that stocks turned up so sharply in late 2008 was monetary stimulus. In November 2008, the Fed started QE1, which would at first buy $600 billion in securities, and China unleashed a $586 billion stimulus package.

Fast-forward almost five years and not much has changed. Except in 2013, Chinese stimulus is in the form of lending — US$1 trillion worth was lent out in the first quarter of 2013 alone.

And the big growth in central bank balance sheets is from Japan’s new program to buy $75 billion of securities a month til the end of 2014…this on top of the Fed’s current $85 million a month program.

There is a great deal of capital moving into the markets, as there was in late 2008.

In so many ways the market is just the same as it was back then. Resource stocks are hugely oversold after capitulation-driven falls. The mood is intensely bearish. Cash is tight, and many stocks with the right stuff are trading at single digit prices. And to complete the recipe, we have a torrent of liquidity heading towards the market.

I won’t say that the market will turn up soon. It could fall further, and a bottom could take 3–6 months to form, but once that is done, we have all the pieces in place for these deeply unloved juniors to be many times higher  in a few years than they are today.

Dr Alex Cowie
Editor, Diggers & Drillers

Ed Note: With Aussie small-cap miners back to 2008 lows it’s easy to say the worst is over. But Doc Cowie says more falls could be on the cards. In today’s Money Morning Premium Notes, Kris focuses on a stock that could give investors a clue about the next move for the Aussie resource sector. To find out more, click here to upgrade now.

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