>RESOURCES SECTOR (MACQUARIE RESEARCH)

HUNTING FOR VALUE

Utilising the data
Resource equity performance has stalled to some degree as the market has chased beta elsewhere. In that context, we’ve considered a range of relationships in order to build our investment thesis and believe the environment remains ripe for the ongoing recovery in earnings momentum and more selective resource equity performance.

To that end, we’ve concluded that the rate of change in capacity utilisation is more important to equity performance than the absolute level itself despite the apparent need for industry activity to approach capacity rates before higher prices can be sustained.

With that in mind, we expect restocking in the Western World to drive the next leg of demand and (in a generic sense) higher industry utilisation rates following what looks to have been a deep destocking cycle over the last 12 months. In fact, when new orders in the US are compared with inventories we see the potential for a major inventory cycle recovery with direct parallels to the 1974 experience. Therefore, should China remain the positive influence on demand that we expect, it is only reasonable to expect another strong period for commodity markets and robust operating margins.

Hunting for value
That being said, the market has moved in breathtaking fashion to reflect the improved operating outlook. Therefore, despite broad-based upgrades across the complex, it’s only those commodities that express scarcity characteristics where we see the potential for a sustainable move above current spot rates. Once again, copper and coking coal stand out while China’s insatiable appetite for iron ore is expected to re-establish the benchmarks upward trend next year.

For the equities, the likelihood of broad based strength is positive for many of the companies under our coverage. However, with stronger cash flows and revitalised balance sheets the miners are no longer being priced for failure. Rather, in many cases, we’ve actually been surprised by the speed at which the market has been willing to price in the bull case. That reality has left us searching for value which is rapidly becoming as scarce as some of the commodities themselves. That’s not to say that momentum can’t carry the day – it can – although we’re much more comfortable with those companies that are exposed to our favoured commodities while retaining fundamental appeal.

To see full report: RESOURCES SECTOR