Macro Investor: The five most undervalued stocks on the ASX

Buy low and sell high. That’s the stock-picker’s guide to success. But is it that simple? Just because something is undervalued doesn’t mean it’s worth owning, sometimes to the contrary.

At Macro Investor we spend a lot of time stocks identifying stocks that are undervalued, not just right now but also their future valuations. But that’s only the beginning. There are other just as important pieces to the investment puzzle.

To demonstrate, here’s Macro Investor’s most recent top 5 list of undervalued companies:

 

So, if these are the most undervalued stocks on the ASX, should we race out and buy them? Well…no!

Straight off the bat we see that the top two, IMF Australia (ASX:IMF), a litigation funder for large class actions and Chorus Ltd (ASX:CNU) , an emerging fixed line IT company based in New Zealand, have been graded “Avoid” based on their financials.

This means that their most recent financial history is not robust enough for further consideration as an investment. Although this could change in the coming earnings season. In particular, Chorus has only been listed a short time, even though forecast profit and Return on Equity (the ability of management to turn shareholder’s funds into profit) look very impressive.

IMF on the other hand has a longer history, with an impressive track record. But because of the nature of its business – you can’t schedule who gets sued when – it has very lumpy cashflow as earnings from class actions come, with big breaks in between.

So already we’ve eliminated two very undervalued and possible investment stocks, but that’s not to say we can’t come back to revisit them, or indeed treat them as more speculative investments, with a view to a smaller allocation and shorter holding timeframe.

When you build a portfolio of good investments, you really need to be stern with your criteria, and only include stocks that have a good track record and a solid financial history.

What makes the remaining trio more exciting is clearly evident in this next table:

 

Macro Investor rates the next two stocks, iron ore producer Fortescue Metals (ASX:FMG) and gold miner St Barbara (ASX:SBM), as “Core” holdings, which means their financial metrics are top rated and the stocks should be considered first when allocating your portfolio.

Remember, good investing is not just picking the right stocks – you need to be able to weight your picks properly, providing you with the best probability of the highest possible return, but at the lowest risk.

We rate the last on our list, which is also a gold miner – Troy Resources (TRY), as “Investment Grade”, one step below “Core”. This is because while it is very profitable, it has seen both a reduction in its book value and it has cut it dividend. This doesn’t mean it’s off the table – rather we prefer to stack our portfolio with “Core” stocks first.

So, we have whittled out list of the five most undervalued stocks to a list of just two. Now we add further macro criteria to see if these two are worth owning.

Troy’s fate is obviously tied directly to the speculative moves of gold, which in AUD terms has fallen over 16% in the last year. Even though it is profitable with good margins, it’s the perception of that profitability that moves prices and if gold continues to slide, those margins could disappear rather quickly. Another uncertainty is whether or when the US Federal Reserve will embark on another round of Quantitative Easing, which will affect the price of gold and the Australian dollar.

The same sentiment applies to iron ore extractor FMG, with the added market dynamic of international hedge funds taking short positions in the stock. Even though spot iron ore prices are well above the cost of extraction for FMG, which we estimate is around $70 per tonne, its medium term fortune is divined by their direction. With an established and accelerating downtrend in place for iron ore, FMG will remain profitable but current earnings estimates will be pared well back, thus reducing value. Its primary macro consideration is the question of to what extent will China stimulate further infrastructure spending? The answer is tied up with its leadership transition and the shift of its economy to consumer-led growth.

So, now, we have two of the most undervalued stocks on ASX, with good financial metrics and a bunch of macro risks.

Finally, we need to apply an assessment of the market condition of these stocks. Macro Investor judges Fortescue to be in a bear market, which means the probability of further price falls outweighs the “falling knife” chance of catching a meaningful recovery.

On the other hand, Troy Resources, even though undervalued, has had a good run and the Macro Investor system is signaling “Take Profit”, which means to reduce allocation by at least half. Why? Well here’s a stock that’s increased almost eightfold since March 2009 as the gold price also shot up, yet has now “moved” sideways for over twelve months while offering no meaningful yield to compensate the holding period. In addition the risks around a correction in the gold price are too high, so its time to re-allocate your capital in other places that may provide a better chance of capital return or meaningful yield.

And there you have it. The five most undervalued stocks on the ASX, aren’t worth owning, in our view.

The key to investment is not to grab every undervalued pick that comes along, afraid that you will miss out on a bargain. Opportunities will always arise, in every market. It takes more than a calculator to be a good investor. You just can’t solely rely upon an automated answer or scan – you need to dig deeper and ask the questions about risk, about the big picture, about why the stock price is so under “valued”?

Maybe the value doesn’t exist at all and its just price you are chasing.

Chris Becker is an investment strategist at Macro Investor, Australia’s independent investment newsletter covering stocks, trades, property and fixed interest. Each week Macro Investor publishes tables on the top ten most undervalued and overvalued stocks on the ASX. A free 21-day trial is available at the site.

14 Responses to “ “Macro Investor: The five most undervalued stocks on the ASX”

  1. ajostu says:

    I’m interested in your relative lack of comment about SBM. Anyone who looked at a recent chart of SBM by itself would have to wonder What Is Going On: they’ve launched an ambitious/clever/foolhardy takeover of ALD. Trying to work out which of tehse three is correct is all part of the fun. Did this figure in rejecting them from the buy list, or are you just using the same criterion as TRY (risk of correction in gold price)?

    • The Prince says:

      space (this article is being run in today’s Business Day, as part of our weekly series there) didnt allow ajostu – thanks for question.

      The risk score for SBM is similar to TRY

      SBM has an “Avoid” signal due to its market condition – and whilst at first glance it is a “Core” stock, it actually fits in the speculative category.

      The point being, you can’t just rely on snapshot screening, you have to dig deeper.

      I would prefer TRY, for the reasons BB outlines below, even though from initial screening it is one step below SBM.

      The major risk factor with TRY is its run up in price (BB: I got that calc wrong, its closer to 8 times low to high, my mistake), hence the “Take Profit” signal (but still hold 50% or so of position), and the correlation with gold AUD price.

      BB: of the 32 gold miners we follow, 7 are undervalued (for FY12), while 18 are undervalued on FY13 forecasts.

      And only 10 make the grade as investment quality, at first screen (we use 5 major factors, this is just the first)

      None have buy signals.

      And most of them are the ones you cover on your blog! So FARM must be doing something right?

      • Thanks, interesting stats and I would say if the model has picked up TRY this way something must be right. Might have to take a look at SBM.

        Out of curiosity, where did the initial 32 Gold stocks come from (as there are far more than that on the ASX with Gold focus)? Is that simply a list of those in the ASX300 or handpicked for other reasons?

        I think point you ended the article on was an important one, there is definitely more to finding the right companies to buy than “running the numbers”.

  2. So 2 out of 3 of the most undervalued stocks (ignoring those with avoid label) on the ASX are Gold miners… this does not surprise.

    I hold Troy Resources in my Super and will be looking to add to that position in the near future.

    I first bought TRY in early 2009 when it was trading at little more than cash backing. The rise from that time was not only a result of an increasing Gold price, they purchased their flagship Casposo project in March 2009 and didn’t start building the plant until late in the same year with first Gold pour in late 2010. The rise has come with much success in delivering (another) profitable Gold mine.

    TRY is also one of the few ASX200 miners who also have significant exposure to movements in the Silver price (Silver credits reduce their cash costs for Gold at Casposo, Q1 US$407/oz net of silver credits). They have a pretty big buffer in their margins in the case of a short term drop in the Gold price.

    The ninefold increase you mention, I assume this was in market cap (?) as the share price has only risen around 4x from March 2009 levels.

    • Rich says:

      BB, do you have an opinion on UML?

      • Not specifically Rich, but looking at balance sheet their market cap is around 80% backed with ($44m) cash. In the case of a company like this you would want to know be confident in managements plan and ability to use the cash wisely.

  3. Jack says:

    Prince

    what is your view re platinum producers, do you think that it has been oversold.

  4. han says:

    everyone should check out ranting andy hoffman on youtube.paper gold and silver are manipulated.

  5. Pantone says:

    Fortescue Metals? I’d recommend a reading John Hempton’s post on them before buying.

    http://brontecapital.blogspot.com.au/2012/06/how-business-decisions-are-made-in-boom.html

    • The Prince says:

      Good point Pantone – I actually had a good chat with John after he posted that, discussing the vagaries of FMG’s production numbers etc. I also talked to Charlie Aitken – who admittedly loves the stock – and he, like many other analysts have a “hope” affair with it – i.e they hope everything goes to plan and they hope iron ore prices stay up….

      That’s called speculation, and there’s always a place for it…

  6. Yippee ki-yay says:

    Even though spot iron ore prices are well above the cost of extraction for FMG, which we estimate is around $70 per tonne,…

    I have never owned FMG but $70 seems very high for them. I was under the impression it was mid 50s. How are you arriving at this number?

  7. 88888 says:

    FMG has terrible metrics – suckers are tricked into the perfect world DCF and 2014 PEs with assumed (hopeful) high iron ore price

    It has an overgeared balance sheet exposed to a falling iron ore price.

    FMG cash costs below $50 are irrelevant when they have so much debt to repay.

    Some would argue they will be raising money (equiity) if/when we go sub $100 iron ore

    I can’t believe the writer thinks this is a core holding – it is a binary outcome – the shorts aren’t idiots

    FMG is a great example of ‘value’ investors torching themselves because they have no feel for the macro.

  8. richardgere says:

    Nice article. It is helpful for dividend investors to choose dividend stocks.
    Thanks