With the resources sector enduring a major slump, it is difficult for investors to determine whether companies operating within that space offer a desirable risk/reward ratio. After all, the problems they are facing are mostly external and, while it is possible to have a view on whether the prices of commodities will rise or fall, doing so accurately and consistently can be somewhat more challenging.
As a result, many investors are steering clear of the sector due to the great amount of uncertainty that is currently present. However, this may not prove to be the right strategy to adopt, since with ultra-low valuations on offer, there is the potential to generate significant profit in the long run for investors that can live with relatively high levels of volatility.
Of course, a simple way to reduce risk and increase potential returns is to demand a high margin of safety before purchasing a resources company. Certainly, a margin of safety is always a good idea but, with the future for the industry being so uncertain, simply increasing its required level seems to be a prudent means of making profit a more likely outcome than a loss.
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One stock which has a very wide margin of safety at the present time is Genel Energy (LSE: GENL). It operates in Iraq/Kurdistan, and so requires an even wider margin of safety than a resources company located in more a more stable environment, owing to the conflict that is ongoing in the region. And, with Genel’s share price having fallen by over 50% this year, investors are pricing in challenges for the company over the short to medium term.
However, Genel still trades on a price to earnings (P/E) ratio of 20.5, which is hardly dirt cheap. Its forecasts, though, indicate that such a rating is rather low, given that the company is expected to return to profitability this year and then deliver a rise in earnings of 58% next year. Furthermore, with Genel having a price to book (P/B) ratio of just 0.4, its shares appear to have limited risk and vast potential rewards.
Similarly, copper miner Antofagasta (LSE: ANTO) may at first appear to be rather overpriced. After all, it has a P/E ratio of 29 which, when it is considered that its sales are expected to slump from £3.5bn last year to £2.7bn in the current year, seems to be rather rich. However, while this year is set to be disappointing, next year is due to be much, much better since top line growth of 21% is currently being pencilled in by the market. This should translate into earnings growth of 76%, which puts Antofagasta on a price to earnings growth (PEG) ratio of just 0.2.
Meanwhile, North Sea oil producer Enquest (LSE: ENQ) recently reported a challenging set of results. Although its production increased by over 17% in the first six months of the year, its revenue fell by almost 12% versus the same period last year and, as a result, its earnings look set to decline heavily in the current year before moving into loss-making territory next year.
Clearly, Enquest is suffering from a lower oil price, but is also not aided by its exposure to the traditionally higher cost region of the North Sea. And, with costs becoming an increasingly important factor as margins across the industry come under pressure, this looks set to count against it over the medium term. As such, it appears to be worth watching, but not investing in, at the present time.
