It wouldn't be the first time.
Perhaps in a rush to be the first in the queue to suggest to their clients that resources stocks are cheap and we are at the bottom of the commodity price cycle, investment banks UBS and Morgan Stanley have changed their tune on some stocks in the resources sector. It pays to remember that both banks are brokers, so getting their heavyweight clients to trade is one way they make money.
Overnight, Morgan Stanley upgraded miners to overweight – whatever that is supposed to mean – rather than calling them a 'Buy'. BHP Billiton Limited's (ASX: BHP) London Stock Exchange-traded shares jumped 4.9% on the call.
Now UBS's Australian equities team says the market is being too pessimistic about resources stocks. On a price-to-book (P/B) basis, UBS says resource and resources-related stocks were heavily represented in their cheapest 10 stocks.
Santos Limited (ASX: STO), BlueScope Steel Limited (ASX: BSL), Origin Energy Limited (ASX: ORG), South32 Ltd (ASX: S32) and iron ore miner Fortescue Metals Group Limited (ASX: FMG) were some of the resources stocks looking cheap according to UBS.
But what they might have failed to consider is that book values could fall much further, making resources companies more expensive on a P/B basis.
Book value takes into account the assets and liabilities the company holds on its balance sheet. Theoretically, if book value is higher than the current market cap, then an investor (a very rich one) could buy the company, sell off all the assets, pay off the liabilities and still make a profit. One such company is coal miner New Hope Corporation Limited (ASX: NHC). The company's net tangible book value per share was worth $2.21 at the end of July 2015, but it's current share price is $1.95.
Resources companies also hold assets such as the value of their mines and mining assets on their balance sheet. As many mining services have found out recently, book value means nothing when virtually no one wants to buy your assets. In some cases, some mining equipment companies were taking heavily discounted prices for their equipment – up to 70% off, when they could sell at all.
With commodities prices falling, the value of the resources companies mining assets many no longer be worth what they have recorded them at on their balance sheet. To give you two examples, New Hope values its exploration and evaluation assets at $377 million – but falling coal prices could mean the company is forced to write down the value of those assets – hence reducing book value and pushing the P/B ratio higher.
Santos values its oil and gas assets at $19.6 billion, with a large chunk of that tied up in its 30% share of the Gladstone LNG processing plant. But if GLNG is not as profitable as expected, Santos could easily be forced to write down at least part of those assets, again reducing book value.
Foolish takeaway
It can be foolish (lower case 'f') to value resources stocks on a price to book basis when there is a high risk that those companies will be forced to write-down the value of their mining assets at some future date. If commodity prices continue to stay low or fall further, it's a near certainty.
Resources stocks might be cheap on a P/B basis – but there's a very good reason why the market is valuing them as such. Buyer beware.
