The next hot sector in small caps? Mining stocks.
That's the view of UBS' small companies team, which invests in small and mid cap stocks, who say the miners that have managed to make it through the savage downturn following the nation's biggest mining boom are now poised to reap the benefits of their survival skills.
Investors remain nervous about the resources sector amid the prospect of higher interest rates in the US sending the US dollar higher, while the Australian dollar continues to bounce around and as a result is clouding the outlook for commodities, UBS Small Companies Fund portfolio manager Stephen Wood said.
But out of the "mish-mash" of factors is the fact that demand for commodities has stabilised, and companies that have spent the past five years cutting the fat and creating efficiencies are becoming attractive buying opportunities.
"There's a whole lot of things over the past five years that have crept into the industry that has helped those guys cut their costs," UBS Small Companies Fund portfolio manager David Haddad said.
"What we've seen over five years or more is a huge increase in efficiency. The competition for labour has disappeared. The cost of engineers is 30 to 40 per cent lower than it was three to four years ago."
Fortescue Metals Group is one company that has managed to reduce its operating costs from $US30 a tonne to $US13 a tonne, and its break-even price to around $US30 a tonne, well able to withstand a correction in the current iron ore price, which is trading at around $US50 a tonne.
UBS also identified Sundance Resources as one of its mining stock picks.
Whitehaven Coal also was a beneficiary of surviving the lean times, Mr Haddad said. No longer paying for ship delays in the busy Newcastle port, it can now save money by shipping ahead of schedule.
"They get the double whammy of the labour markets have freed up and the infrastructure in place to improve the supply chain. They don't have all those smaller producers coming in as well."
But the mining stocks are still on the nose with many investors, and that creates an opportunity to buy these companies at rock bottom, especially in the small cap space, in comparison to the in-demand industrials.
"Some of the top quality small cap industrial stocks have got pretty expensive. Where the unloved resources names are sitting at three times cash flow, others are sitting at 50 times," Mr Wood said.
Resources earnings expectations remain subdued, however. In a recent research note Citi equity strategist Tony Brennan said at 27-times earnings, the market appeared to have factored in the prospect of commodity prices remaining at their current levels. But earnings forecasts have yet to catch up, he said.
"Resource earnings forecasts don't yet seem to envisage spot commodity prices persisting, somewhat understandably given the uncertainty about China, but current prices would mean higher resource earnings were they to continue," he said.
However, according to Citi Research, earnings per share growth is set to turn around in the resources sector, from a fall of 53.1 per cent in the 2016 financial year to growth of 14.8 per cent in 2017.
Mr Wood acknowledged the risk of investing in small cap miners and advised diversification. UBS is also invested in lithium miners Galaxy Resources, Orocobre Limited and Pilbara Minerals, as lithium batteries become more in demand in the renewable energy industry.
But the "very long" time frame of the transition out of fossil fuels warrants investing in mining stocks, he said.
"At the end of the day you have to recognise, whether it's oil or coal, at some point the transacted volume is going to peak. But that doesn't mean that if a very high quality, low cost producer has been sold off for three-times cash flow, it's not a good investment," Mr Wood said.
