Resource valuations: Too stretched or reflecting future earnings?

Thereturns from the different sectors of theJSE have been very disparate, especially over the last year. Many resource stocks, specifically, have shown spectacular gains, while industrial andfinancial stocks have lagged. At the beginning of 2007, the historic price-earnings (PE) ratios of the three broad sectors were similar, yet they currently vary significantly (financials 13, industrials 16 and resources 23).

Have resource valuations become too stretched or do they reflect future earnings in a commodity super-cycle? How do youbalance the risks of forecasting an uncertain future?

At Nedgroup Investments we know that our investors might be asking the same questions. Nic Andrew, Head of Nedgroup Investments, asked three of its fund manager partners for their comments. This is what they have to say:

Speaking on behalf of the Nedgroup Investments Value and Stable Funds, William Fraser, responds: “You correctly point out that the returns on the different sectors in the market have been disparate, and have resulted in resource PE’s expanding to record relative ratings. Resources have had the benefit of not only rising raw material prices but also a weakening currency. Operational gearing within resource companies, translate into even more rapidly growing earnings. This increase in earnings growth is providing the impetus for share prices, as earnings have surprised and continue to surprise the market.

The immediate future, therefore, appears to be extremely positive for the earnings growth from resource companies, even if raw material prices retrace from current levels. A 70% growth in earnings will translate into a forward PE of 13 times – significantly less elevated that the current 23 times earnings, but not cheap by historical standards given the duration of the current cycle.

We focus on the earnings growth potential of individual companies, using bottom up models. Importantly, we take into account a wide variety of probable outcomes, and identify key risks to the earnings growth potential of companies. We use this probabilistic approach to identify companies that are mispriced. Earnings growth for the resource sector will peak in the next 6 to 12 months, but there are individual companies that continue to show good potential beyond the immediate future. We do not know the exact path of future prices, but a focus on earnings helps us identify future winners or losers.”

Daniel Malan (Nedgroup Investments Managed Fund), said: “In the second half of2006 we closed our domestic funds to new inflows, because our bottom up research indicated that the investable universe of cheap opportunities across all industry sectors in South Africa was too small at the time.

We don't do any forecasting - we inform our investment actions by looking at what businesses achieve over the long runthrough many business cycles, andformulate an understanding of their business models. Our research points to resource share prices currently discounting more than a perfect outcome over the next ten years - in which case the opportunity to make excess returns is very low. The deck is loaded against investors in this sector. If anything goes wrong with the super cycle argument - and there is mounting evidence that this should be at bestascribed asmall possibility -there is considerable downside.

What we do know is thatone way ofreceiving excess returns from the stock market over the long runis to invest into situations that are priced on the basis of low expectations. When these are met downside is typically minimal, but if they are exceeded the upside can be substantial. Basically such situations offer very favourable odds, and we focus our attention and fund capital allocation on that.”

Omri Thomas, speaking on behalf of the Nedgroup Investments Rainmaker and Entrepreneur Funds said that resource valuations do appear to be stretched, whether one looks at the earnings yield of these companies on their own, or relative to interest rates/long bond yields or relative to yields offered by financials (which on a historic basis look attractive even relative to current high interest rates).

“Of course this has a lot to do with the outlook for the various sectors with the resources sector being aligned with the positive Asian economic environment and financials being aligned with the uncertain local environment. While there are concerns that commodities could roll over from these high levels it does appear that downside is limited by genuine scarcities and rising costs of bringing new capacity into production. In addition, from a local investors’ perspective, any weakness in commodity prices is likely to be compensated for by currency weakness. On the other hand the financial sector faces growing political uncertainty, rand weakness, rising bad debts, rising inflation, rising interest rates, declining consumer spending and declining corporate investment spending, all of which could combine to exacerbate an already tense socio political situation thereby fuelling the risk of further currency depreciation.

At the end of the day, while Anglo American appears expensive based on historic earnings, it trades on approximately eight times forward earnings multiple compared to Standard Bank’s estimated 7.5 times.”