High returns bring high risks but what if I told you that high returns could be achieved by taking a calculated risk today?
Take BP (LSE: BP), for instance: a company whose stock falling7.3% on Black Monday trades between 30% and 80% below fair value, based on certain assumptions.
Yet if you arebetting on a resurgence in commodity stocks such as those of Rio Tinto (LSE: RIO) and Antofagasta (LSE: ANTO), which are down 24% and 30%, respectively, this year well,think again.
Lets take a look at the two miners before we move on to the value play of the year.
Rio &Antofagasta: Its AMatter Of Price Now!
Rio and Antofagasta are similarly troubled, although their core businesses are rather different. Antofagasta released its interim results today, which did not move the needle.
I wont bother you with their underlying operations, their global exposure and why their shareholders are in deep trouble just consider that China is a problem that is being overstated by many observers, in my view.
Here, the problem goes to the heart of valuation indeed, the problem is thevaluation of assets in the mining sector.
The assets write-down cycle whereby certain assets must be either valued or sold below book value as market prices plunge is going to bring diminished economic profits and low proceeds from divestments for some time. Anglo Americans $300m fire-sale of its copper mines in Chile this week proves the point.
Prices for copper have tumbled, so Antofagasta finds itself in a hard place but itsbalance sheet is sound, given that it shows a net cash position.Its forward yield is just above 2%, and doesnt signal much risk. The problem is that its shares trade on a price-to-earnings (P/E) multiple of 16, and that is not a valuation youd like to pay for a commodity house these days.
How about a more appealing target at 13x forward P/E, though?Thats where Rios stock trades, yet itsforward dividend yield is north of 6%.
A Wrong Strategy Counts More Than A Sluggish Cycle
Just likeBHP Billiton, Rio is paying the price of a wrong strategy in iron ore production. Its managers were blind, and couldnt predict a challenging commodity cycle that eventually caught up with reality.Blame the legacy of the credit crunch sluggish growth for their woes!
I think UK investors overreacted yesterday, and itcould soon be all over the marketmay even forgive Rio.
Operationally, however, its strategic decisions have been a disgrace.On top of that, the rejection of Glencores approach last year was a disaster for both miners. Financially, then, it doesnt look like its management team has considered all the options it has at its disposal to deliver value, either it seems that investors believe Rios yield, which is covered, is too high and cant be sustained.
The obvious advice? Chop it!Admittedly, its latest results were not too bad, but thenits cash-burn rate wouldnt let you sleep well at night ifyour name was on the shareholder register.
BP Is A Steal At This Price
Oversupply is the oil industry is an issue that will be forgotten in less than a year, in my view. TheOrganization of the Petroleum Exporting Countries (OPEC) wont sit idle for long, while the reading of US inventory data is less bearish than many suggest, although a decline didnt materialise in recent days.
Investors on Monday seemed to believe that the world was going to end pretty soon, and heres the common thinking: commodity stocks are doomed andBP, of course, will have to cut its dividend neither of which is a very likely outcome, in my opinion.
It was always going to be a tough ride.
Back in February we said that we anticipated a reset phase lasting around two years, during which our aim is to rebalance the Groups sources and uses of cash to underpin our dividend, BPs boss,Bob Dudley, told analysts after BPslatest trading update on 28 July. Since then,the stock has fallen a lot, as it happened, recording a -14% performance in less than a month.
I am confident that positioning BP for a period of weaker prices is the right course to take, and will serve the company well for the future, Mr Dudley added.
I have no doubts that BP will deliver and that view is backed by strong fundamentals, and its recent settlement of the 2010 oil spill.
Oil Prices Down So What?
According to the oil and gas producer: In the second quarter the Brent crude price averaged $62 a barrel, compared with $54 a barrel in the first quarter and $110 a barrel in 2Q 2014. In the third quarter to date, the price has averaged $58 a barrel, BT said in its second-quarter results.
If Brent crude continues to trade at about $45 a barrel, its price in the third quarter will average around $50 a barrel, which is only 9% below $54 a barrel in the first quarter,but back then BP traded between 392p and 457p.BPstock now trades at 335p a stock price that is insanely low based on BPs financials.
In this environment, BP will likely be able to generate at least $20bn of unadjusted operating cash flow to support$18bn/$20bn of annual capital expenditures.That also depends on a number of variables, including working capital management, which should provide a boost in the second half of the year as its inventory converts into cash.
Even if BP was to pay all the dividend to equity using cash on hand (40 cents a share for the year, or 10 cents quarterly), its implied net leverage would be well within reasonable levels.
In fact, BP could raise more debt!
BP has accumulated a huge a amount of cash more than $30bn that it can use in torrid times such as these.Finally, it still has to fetch about $3bn from divestments, but even if we assigned zero to the value of those assets, Id still be bullish!
Of course, if the Chinese economy hits a brick wall, growing only at 5% a year, well have to reconsider the investment case. Regardless of whether you trust Chinas GDP growth number or not, China is more likely to grow between 6.5% and 7% over the medium term which is not necessarily a hard landing scenario, as a banker reminded me today.
Looking For Value
Along with BP, I suggest you create a portfolio including income andgrowth stocksthat have become even more compelling following the current market turmoil.
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Alessandro Pasetti has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.
