1. How to use GuruFocus - Tutorials
  2. What Is in the GuruFocus Premium Membership?
  3. A DIY Guide on How to Invest Using Guru Strategies
Warwick Bagnall
Warwick Bagnall
Articles (2)  | Author's Website |

Cyclical Resource Stocks: Finding Babies in the Bathwater

4 categories of situations where companies in the cyclical resources sector may be resilient enough to survive a downturn

April 15, 2018 | About:

Many industries are cyclical to a degree, due to either external factors such as consumer demand or due to boom-and-bust capital investment cycles. Mining and oil and gas are two of the most cyclical industries due to large fluctuations in commodity prices coupled with high fixed capital requirements.

Because the mining and oil and gas businesses tend to be capital-intensive, they tend to have a lot of operational leverage. So when commodity prices are low, they haemorrhage cash and when prices are high, they have high returns on capital. Because of this, they tend to sell for multiples of their replacement cost at the peak of the cycle, but tend to screen well from a trailing earnings point of view, making them traps for the unwary value investor.

At the bottom of the cycle, the majority of companies in a particular sector can be loss-making. Bankruptcies and recapitalizations are common. I don’t like my chances of predicting the timing of a cycle upturn, so for me this makes many commodity companies uninvestable – I can’t reliably predict if they will survive to see the next upturn. So under what circumstances could a commodity company be considered a worthwhile investment during a downturn?

I think companies which are still able to produce positive free cash flow when the price of a commodity has crashed and lain on the floor for at least a couple of years are worth looking over for evidence they can endure a prolonged downturn. Companies which have managed to keep producing free cash flow could be doing so for four reasons – forward contracts, low-cost production, cost-plus contracts and low capital intensiveness:

  • Forward contracts for the purchase of a commodity, negotiated during a period of higher prices and which are still being filled, can help a company maintain profitability during periods of low commodity prices. An example of this would be a uranium producer which has forward-contracted supply to a utility company for a multiyear contract. In this case, I’d be very cautious – companies in this situation are likely to be a good bet only if they are also a low-cost producer, unless the length of the forward contracts is extremely long.
  • Low-cost producers can sometimes produce free cash flow even when the rest of the industry is unprofitable. An example of this is the iron-ore division of BHP (ASX:BHP) or Fortescue Metals Group (ASX:FMG), both of which were able to produce positive free cahs flow during the downturn in iron ore prices in recent years. To have confidence in this sort of situation, the durability of the cost advantage needs to be examined. Factors such as the amount of remaining low-cost reserves and the long-term average amount of maintenance capital expenditure required to maintain low production costs should be examined.
  • Cost-plus contracts mean a company earns the same profit margin, even if the price of the commodity they deal in decreases. Contract mining companies such as NACCO (NYSE:NC) are an example of this. Geoff Gannon has written about NACCO elsewhere on GuruFocus.
  • Finally, my favorite area to look for are companies that require little maintenance capital to continue to operate and have little operational leverage. This means that during a downturn they can shrink without needing ongoing injections of capital to maintain equipment. It also means that if sales decline, they can continue to operate at a profit. It doesn’t necessarily mean they operate in a market that has barriers to entry, though. Low capital requirements would suggest market entry is relatively easy during boom times. If entry requires significant learning or customer relationships, however, this type of company could not only survive a downturn, but also be able to charge highly lucrative prices during a subsequent upturn. Matrix Composites & Engineering (ASX:MCE) is an example of a company that falls into this category. Matrix is an oil and gas equipment supplier that has managed to stay free cash flow-positive by shrinking its operations since the decline in the oil and gas industry began in 2014. The batch-wise production process Matrix uses means fixed production costs can quickly be reduced and maintenance capital expenditure requirements are much lower than depreciation.

So whilst resource stocks are generally a speculation rather than an investment, there are occasionally exceptional cases that have the qualities of an investment. And as with a lot of things in the field of value investment, it’s the exceptions to the general case that provide the opportunities.

Disclosure: We currently hold MCE. This is not a recommendation to buy or sell any securities. All information presented is believed to be reliable and is for information purposes only. Do your own research before purchasing any security.

Check out more articles on ASX-listed stocks at Oceania Value.

About the author:


Rating: 0.0/5 (0 votes)

Comments

Please leave your comment:


Performances of the stocks mentioned by Warwick Bagnall


User Generated Screeners


Yamil BerardTepper's Leisure
jtepper2GrowthHighROC
gluon71gm-buylist-4
gluon71gm-buylist-3
DBrizancdn 18Jul2018 1249p
DBrizancdn 18Jul2018 1248p
HOLKLSUTop 20 Group 2018 All Sectors
DBrizancdn 18Jul2018 1219p
averacjrgood beta in up market
Nightdoc2S&P 500 quality
Get WordPress Plugins for easy affiliate links on Stock Tickers and Guru Names | Earn affiliate commissions by embedding GuruFocus Charts
GuruFocus Affiliate Program: Earn up to $400 per referral. ( Learn More)

GF Chat

{{numOfNotice}}
FEEDBACK