When investing in resources companies, there’s always a danger of a major correction. That’s because they depend so heavily on the price of commodities that their profitability can easily swing wildly between positive and negative depending on the price of the commodity that they mine or produce. And even if they’re in exploration rather than production, investor sentiment can rapidly change due to a movement in commodity prices, making them just as volatile.
As a result of this, a correction could be just around the corner for all resources companies. However, this realisation is perhaps more palpable today after a horrific period for miners and oil producers that has seen billions wiped off their valuations. So it seems prudent to seek out only those companies with a wide margin of safety, given the scope for a renewed fall in commodity prices over the short-to-medium term.
One company that seems to offer a sufficiently wide margin of safety is Antofagasta (LSE: ANTO). The diversified mining company has strengthened its financial position through sales of non-core assets such as its water services division, while at the same time seeking to improve efficiencies to make its cost curve even lower. This is set to have a positive impact on the company’s profitability and with Antofagasta trading on a price-to-earnings growth (PEG) ratio of just 0.4, it appears to have a wide margin of safety and strong capital gain potential.
Furthermore, with the price of gold likely to benefit from slower-than-expected interest rate rises and proving popular during uncertain periods, Antofagasta’s exposure to the precious metal could cause investor sentiment to improve relative to its mining peers. While this doesn’t make Antofagasta a defensive stock, it does provide its investors with a degree of diversification.
Also offering a relatively wide margin of safety is oil producer Premier Oil (LSE: PMO). Like Antofagasta, it seems to have a sound strategy to not only survive the present difficulties within the oil sector, but to also take advantage of them. It has slashed costs and become a more efficient entity, while also planning for future growth through the acquisition of EON’s North Sea assets.
While this could help Premier Oil to deliver rising profitability in the long run, the company is expected to stay in the red in the current financial year and the next one. While this would be disappointing, Premier Oil’s price-to-book (P/B) ratio of just 0.5 indicates that it offers a sufficiently wide margin of safety to make it a relatively appealing long-term buy.
Meanwhile, Cairn Energy (LSE: CNE) continues to appeal regarding its long-term profit potential, with the exploration play having a sound balance sheet and a highly lucrative asset base. In fact, Cairn has a net cash position of over $600m and this could help to allay concerns among investors regarding funding for its operations over the medium term. And with Cairn’s North Sea assets due to begin production in 2017 and its operations in Senegal being a key focus this year, it may see an improvement in investor sentiment moving forward.
However, with Cairn having a P/B ratio of 0.8, there may be better options elsewhere. Certainly, it may be a stock to watch, but a wider margin of safety may be required before Cairn becomes a buy given the nervous climate in the resources space.
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Peter Stephens 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.