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This article appeared in the August 2012 ASX Investor Update email newsletter. To subscribe to this newsletter please register with the MyASX section or visit the About MyASX page for past editions and more details.

Further losses can't be ruled out, but the mining sector's long-term outlook remains strong.

Photo of Allan Trench By Allan Trench, author

There is an old saying on Wall Street that you should not try to catch a falling knife. It will have particular meaning to investors who have sought bargains this year among the long list of mineral explorers and miners listed on ASX.

Although valuations are now more compelling, broader sharemarket weakness has left few companies unscathed by the downturn in risk appetite and share prices, notably since April. The April correction came after what was already a weak year for metals and mining shares.

For all the economic and political commentary on the strength of the resources sector, the 2011-12 financial year ended with the market value of the largest 150 ASX-listed mining stocks, as tracked by Gresham Group, falling some 35 per cent or around $200 billion, from $567 billion at June 30, 2011 to $367 billion a year later.

Those who invested in 2011-2012 will find only limited solace in knowing that market valuations have over-reacted to the downside. Anyone seeking confirmation of this need not look very far. Several exploration companies sitting at the small end of the market, with a capitalisation of $50 million or less and no company debt other than monthly creditors, are trading at a capitalisation, in some cases, substantially below their cash backing per share. That means any share purchases made now buys the company's cash at just cents in the dollar, with the exploration assets thrown in free.

Put simply, the market at present views exploration leases, in some cases, as more of a future liability (carrying a necessity to spend the company's cash) rather than as assets holding potential future value.

Such a situation in the market is unusual; the last time this writer can recall such extensive pessimism was at the low point of the commodity cycle in 2001, and for a short period in the depths of the GFC at the end of 2008 through to March 2009.

World economic factors

The factors that have taken market values to this low point are well known. Europe is struggling to stimulate growth, and to date the efforts at economic austerity have weakened outlooks rather than stabilised them.

The United States is in economic recovery, but that is tenuous, notably sitting in the shadow of the country's stretched balance sheet. Japan is marking time, with its economy still recovering from the 2011 earthquake and tsunami. Even China, that bastion of economic growth, has been questioned on whether it will continue to grow apace, or will it suffer a hard landing below the current 7-8 per cent growth forecast? That rate is already below the Chinese growth benchmarks of recent years.

These global economic risks are real - and it would be imprudent to gloss over them - but it is in such times that investment opportunities can be at their most attractive.

The response of investors has been to sell down mining shares exposed to commodity prices, despite the earnings from established mining operations remaining healthy. So how will the market evolve from here? Answers to the following questions should provide guidance.

Where are we in the mining cycle?

Prevailing commodity prices are well off their highs, with many commodities peaking in the first half of 2011. But prices are still at levels where good money can be made. That is, commodity prices for the most part remain at levels where established operations have strong cash margins. Those struggling to maintain a healthy margin are typically owned by small listed miners who cannot capture the economies of scale available to the likes of BHP Billiton and Rio Tinto. These smaller miners have lower-tier assets of lesser grade, with more difficult mining geometry.

Perhaps counter-intuitively, therefore, mineral explorers can carry less investment risk than small-scale mining operations in the present market - because cash burn (the amount exploration companies spend each month) is far more easily controlled in the former, while small-scale mines remain exposed to month-on-month technical challenges, without the support of sharemarkets should cash flow be hit (i.e. it is harder for them to raise capital).

In the downturn of 2001, zinc miner Pasminco hit the wall as the interplay of metal prices and inappropriate foreign exchange contracts took their toll. In 2012, another zinc miner, Kagara, has also fallen into administration. The Pasminco failure signalled a turning point in zinc back in 2001, and another is looming now, with analysts forecasting a significant upturn in zinc prices by 2014-15.

What lies ahead?

Europe will not be fixed overnight and although the consensus suggests China will continue to grow strongly, the doomsayers on the Chinese economy will react to any weak quarter-by-quarter; indeed, to daily news that may indicate potential macroeconomic slowing of growth below 7 per cent. Further downside to the valuation of miners cannot be ruled out over the balance of 2012.

As for the longer term, China is more critical to commodity markets than Europe is. For readers who are not aware, China has accounted for 100 per cent of net growth in metals consumption globally since the turn of the century. That is, first-use metal production has moved from Western countries to China - to the extent that Western economies have moved backwards on the metric; first the slack, then all the growth, accounted for by China. If China continues its huge urbanisation, which appears inevitable, then metals supply will remain under pressure despite the travails of Europe and only mediocre growth in the US.

The commodities with most appeal

Two commodities away from the mainstream with appeal in the mid-term are uranium and zinc.

Uranium will benefit from China's building of nuclear facilities in the coming two decades. China has already began stockpiling yellowcake, which has kept the uranium price at around US$50 per pound over the past year despite the negative demand shock caused by Fukushima (which has led to Japan, the world's third-largest uranium consumer, and Germany, the world's sixth largest, essentially ceasing new consumption).

China could well do for the uranium market in the next two decades (it is set to become the world's largest consumer by 2030), what it did for iron ore in the last decade. This will not happen overnight, but is a clear long-term trend pushing uranium prices upwards.

Zinc is currently in over-supply, with stockpiles growing. Analysts are united in predicting the over-supply will reverse as several large mines, including Australia's Century mine, run short of ore by 2014-15.

Risk-averse investment plays

The most obvious risk-averse play at present is to consider investing in exploration companies that have market values below their cash backing. In such cases, the cash itself provides some buffer against further reduction in the share price, and the exploration upside remains fully intact for companies continuing test drilling of their prospects.

Whether an explorer hits or misses with drilling has nothing to do with the economy in Europe, or even China. So guidance here would be to seek out those exploration companies with a significant amount of cash at their disposal, exceeding a minimum of $5 million, so there is no near-term need to raise additional funds. (Editor's note: exploration companies typically have higher risks and rewards, and suit experienced investors or traders).

Shares will react positively to good drill intersections, and failing that the company's value should recover as the general sentiment towards explorers recovers. Clearly, detailed company-by-company research is required, and all investors should seek professional counsel.

About the author

Allan Trench is a Professor of Mineral Economics at Curtin Graduate School of Business and Professor (Value and Risk) at the Centre for Exploration Targeting, University of Western Australia; a non-executive director of several resource sector companies; and the Perth representative for CRU Strategies, a division of independent metals and mining advisory CRU Group. He is the author of 'Australia's Next Top Mining Shares - Understanding Risk and Value in Minerals Equities' published by Major Street Publishing.

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