23/04/2008 - 22:00

Market hasn’t hit bottom yet

23/04/2008 - 22:00

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It is now apparent that the financial impact of problems on Wall Street is filtering down to ‘main street’.

It is now apparent that the financial impact of problems on Wall Street is filtering down to ‘main street’. Sub-prime chaos and the resulting fallout in the mortgage belts of many countries around the world will reduce bank lending and have a negative impact on corporate profitability during 2008 and into 2009 as consumers cut back and corporate investment is curtailed.

In a move which caught financial markets by surprise, the second largest company in the US, General Electric, reported that its first quarter profit fell 6 per cent and it lowered forecasts for the second quarter and the rest of the year.

This result, from the giant manufacturing and media company, was seen as a signal that the US may be headed into recession, if indeed it is not already there. Frankly, Briefcase was amazed that this news should have come as such a surprise. I will be in the US when you read this, consulting widely with people in various areas of that vast and important nation. The plan is to report first hand to readers about my impressions from the folks I meet.

Bank malpractice and over-exuberance has so far resulted in about $US400 billion of write downs by banks globally. As if this was not enough, flagging a reduction in bank lending capacity of around $4 trillion into 2009, a recent IMF assessment foretells of up to $1,000 billion of write downs (read losses) which Briefcase believes has not been factored into market valuations going forward. Briefcase remains of the view that global stock markets have undergone a bear market rally and that we should expect new market lows before a base can be called.

While the long-term, stronger-for-longer story for commodity prices is firmly in place, underpinned by the China phenomenon, the short-term story is subject to considerable volatility, should China stumble on its path to the Olympics.

The main worry for Australia is that global economic weakness leads to a mild pullback in commodity prices, which would affect the rating of listed companies. I may be too cautious in this regard, since it is certainly true that a new bull market will be born out of absolute gloom and doom. The only problem I see is that the market has not yet seen that nadir.

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Uncertainty surrounding stocks held by Opes Prime and Lift Capital increases the risks associated with investing in the smaller capitalisation end of the market.

This does not mean that investors should close up shop; far from it. This market and the antics of those which have geared up their illiquid and small companies continues to throw up bargains galore. Problems associated with the likes of Lift Capital and Opes Prime are hammering innocent companies and their uninvolved shareholders, but also present fantastic buying opportunities as the likes of ANZ Bank and Merrill Lynch dump stocks willy-nilly on the market at any price, creating wonderful opportunities as the market acts completely irrationally.

Briefcase regards “ceasing to be substantial shareholder” notices from Merrill Lynch for companies such as Compass Resources and PrimeAg as clues to explain why these otherwise soundly based companies have been hammered in the market and appear to Briefcase to represent sound buying opportunities.

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Briefcase has previously spoken about the tenuous condition of global food inventories, predicting widespread famine by the end of 2008. Recent food riots in Haiti, Egypt and at least 10 other centres are a serious indicator of coming problems. This is very serious stuff indeed and it will be hard for many in the developed world to come to grips with the extent of the problem.

Rising energy costs and limited availability of fertilisers will impact on both food costs and supply. Briefcase estimates that the average farm in Western Australia’s Wheatbelt will spend around $300,000 on diesel this year to get a crop in the ground and then harvested, before accounting for the cost of grain and fertilisers; so a big cheque for the crops will be required to make up for the rising cost of producing food.

Many countries are now restricting trade in essential food commodities, which is sure to further disengage the market and cause panic buying in some sectors. This market action is a foretaste of what Briefcase believes is coming in the global oil market, once the reality of peak oil production hits home.

Briefcase finds it most intriguing that commentators talk about the effect of political upheavals, drought and the impact of grains being used for bio-fuels on food shortage, but virtually no-one talks about the most obvious influence – the rapidly rising and unsustainable human population level – as if that was somehow beyond comment.

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Avoca Resources is a real hometown gold mining success story, having succeeded in taking the Higginsville gold camp from under the nose of Resolute Resources. It has since outlined 1.35 million ounces of high grade, underground mining reserves grading 5.8 grams per tonne of gold. Briefcase calculates that the likely gold resource is already closer to 2 million ounces of gold.

The company has a market capitalisation of just more than $480 million and cash of just under $50 million plus $71 million of debt. Gold production is set to kick off this quarter, building to 170,000 ounces in 2009 and 190,000 ounces in 2010 at cash costs of around $A390/ounce. Experience from mining the Poseidon pit above the target reserves indicates that a high level of nugget gold content in the ore is likely to lead to a 30 per cent under-call on grade, which is likely to come in closer to 8g/t and lift production closer to 240,000 ounces a year.

The company trades with a market capitalisation per ounce of resource of $355/ounce, but adding grade under-call to exploration appeal would reduce this rating towards $200/ounce of resources.

Avoca has strong exploration appeal through a broad portfolio of projects, and should deliver an operating surplus of around $120 million a year and earnings of around 25-30 cents per share, which would support a share price of up to $3/share.

Recent exploration gives confidence of a 10-year mine life at the Athena and Apollo lodes with new discoveries along the line of lode, including an intersection of 76 metres grading over 10g/t gold, which is not included in the 1.35 million ounce reserve base. Avoca has high hopes for additional discovery along a second line of lode, which runs through the Challis gold mine, to the west of its project area. Avoca is also developing regional open pit prospects, including the Musket project.

• Peter Strachan is the author of subscription-based analyst brief StockAnalysis, further information can be found at Stockanalysis.com.au

STANDING BY BUSINESS. TRUSTED BY BUSINESS.

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