No Respect for Natural Resources Despite Strong Earnings Growth

By Eric Fry
Contributor

Commodities

What’s wrong with this picture?

I’ll give you a hint: One of the lines is a lot higher than the other.

The line that’s moving higher is the two-year earnings growth of the S&P North American Natural Resources Sector Index. The line that’s barely moved at all is the value of that index.

In other words, even though earnings in the natural resource sector are soaring, the share prices of most resource stocks are not.

This striking disparity looks like a buying opportunity.

After all, corporate earnings do not often leap by nearly 300% over a two-year span. That robust result suggests something must be going right in this sector.

And yet you’d never know it by looking at the lackluster price trends. As legendary comedian Rodney Dangerfield would say, these stocks don’t get no respect…

“I could tell that my parents hated me,” Dangerfield would joke during his routine. “My bath toys were a toaster and a radio.”

He continued, “I told my psychiatrist that everyone hates me. He said I was being ridiculous – everyone hasn’t met me yet.”

Similarly, resource stocks aren’t hated by everyone… but almost. The chart below, for example, shows the brutish treatment resource stocks are receiving from investors relative to the kind treatment the S&P 500 Index is enjoying…

The bars on the left show that the two-year earnings growth of the S&P North American Natural Resources Sector Index has been roughly 10 times greater than that of the S&P 500 Index.

And yet, as the bars on the right show, the S&P 500 has jumped 35% during the last two years, which is more than the gain of the S&P North American Natural Resources Sector Index over the same time frame.

Inside these resource indexes, many individual stocks are showing an even more striking disconnect between earnings growth and share price trends.

Teck Resources (NYSE: TECK) is a textbook example. This Canadian company derives most of its income from copper, zinc and metallurgical coal.

The company’s operations fell on hard times during the commodity rout of 2011 to 2015, but they’ve staged a sparkling recovery since then. In fact, Teck recently posted its largest annual profit in more than a decade. And yet the stock is selling for less than half the price it hit in 2011…

Clearly the stock price does not fully reflect the company’s recent good fortune. Its stubbornly low valuation is probably due to investor skepticism.

The year may be 2018, but investors in the natural resource sector haven’t forgotten the misery of 2014 and 2015.

The analyst consensus predicts earnings of CA$4.55 (US$3.51) a share this year, which means the stock is selling for just seven times earnings. That’s extraordinarily cheap.

But the stock’s low relative valuation is just one of the three reasons it is likely to move higher, according to Teck CEO Donald Lindsay.

During a question-and-answer session at the Deutsche Bank Global Industrials & Materials Summit, Lindsay stated flatly, “We believe [there] are three areas of significant value potential for Teck.”

He explained each one of these areas and placed a specific per-share number on their potential value to Teck.

This first area was “multiple normalization.” That’s just a fancy way of saying that the stock is too cheap relative to its peer group and therefore should rise to a more “normal” valuation.

Lindsay said a “normal” valuation on Teck stock would boost its price by about CA$15 a share (US$11.55).

The second area Lindsay mentioned was Teck’s huge copper project in Chile, Quebrada Blanca 2. Assuming it begins producing on schedule in 2021, it will become one of the 15 largest copper mines in the world.

Lindsay said this project has the potential to boost Teck’s gross earnings by more than 20% from current levels. And that’s assuming almost no increase in the copper price. “The successful execution of [Quebrada Blanca 2],” he says, “could add over CA$15 (US$11.55) per share in incremental value.”

Lastly, Lindsay mentioned the other area of future profitability that could boost the stock’s value considerably is a large oil sands operation in Canada that just started its initial production a few months ago.

Teck holds a 20.9% interest in the Fort Hills Canada oil sands project. Suncor Energy (NYSE: SU) operates the venture and owns just over half of it. France’s Total (NYSE: TOT) owns the rest (26.05%).

This project required a large capital commitment from Teck. So when oil prices were less than half what they are today, Fort Hills looked like it might be a big dud. But the opposite has happened.

The project is performing above expectations and has the potential to become a big moneymaker.

Bottom line: Teck stock possesses significant upside potential. But this potential isn’t getting any respect from investors.

It isn’t easy being a resource stock at the moment. They get no respect, I tell ya… no respect at all.

But, unlike Rodney Dangerfield, I expect these stocks to begin getting a bit more respect eventually.

Good investing,

Eric