Wednesday, October 19, 2011

Investors Guru Small Cap Stock Observer

(Amex/TSX: URZ) Uranerz Energy - Fall Rally, Headline Risk vs. Long-Term Value, Uranium Bottom?

Will 2011 have a Fall Rally?

Small-cap stocks, and especially resource stocks, tend to perform better over the fall and winter. This seasonality effect is nowhere to be seen you might think. However this time last year weren't we all in the same predicament?

At that time the markets had sold off over the summer on debt concerns in Greece and the other PIIGS countries (Portugal, Italy, Ireland, Greece, Spain). The US had its own debt, deficits, housing, banking and political problems and pundits pondered the likelihood of a double dip recession.

Fear and uncertainty are market killers in the short-term, but at some point stocks get so undervalued that rational investors step in. Momentum traders can't help to follow, and then all of a sudden it's risk-on again.

Despite all the doom and gloom over the summer 2010, the DJIA Dow Jones Industrial Average managed to rally 28% that fall and over the next 8-months, from around 10,000 on September 1, 2010 to 12,876 on May 2, 2011. The point is that an uptrend can happen quickly and when least expected.

The financial messes in the US and Europe seem about the same, don't they? If Greece or another European country or bank fails, does anyone doubt this will just result in the printing of as many trillion Euros as needed? Will next month's debates over the US' debt/deficit cutting measures result in constructive legislation or just another kick of the can further down the road?

The answer is that nobody knows if or when a fall rally could happen. Stats show that over the past 50 years the fourth quarter has been the best for stocks. Also, since 1990 there have been 8 quarters with market losses of more than 10%, followed 6 of these times by gains in the following quarter. Mean reversion and Fibonacci retracement followers may project similar positive fourth quarter outlooks.

These stats are somewhat comforting but really just mean that markets tend to bounce after a selloff, as investors take advantage of lower stock prices. Why not just say Buy-Low Sell-High! In any event the last quarter was particularly bad, with the US markets down almost 14% and close to 10% for the year.

Does any of this headline risk really matter in the long-term?

With the current high volatility, neither longs nor shorts are safe right now. Like the fall of 2008, the market seems extra sensitive to headline risk that continues to cause large percentage swings both up and down across the board.

You might think this attractive for short-term traders, but most of the moves tend to happen in the after-market. By the time the average day trader steps in, they often get squeezed as the market reverses on its next whim.

Day traders usually don't wait for losing positions to work out and tend to close out by the end of the session. When the market swings 6% daily, up 3% early and then down 3% by the close, and vice versa the next day, it is next to impossible to find a reliable trend that won't rollover on you suddenly.

Headline risk does matter greatly if you have to close out your position by the end of the day. Traders compare the buying of market selloffs to catching a falling knife. Traders might want to wait to surf the next big wave and avoid the current choppy waters.

On the other hand this can be an ideal time for near-term position traders and long-term investors. Instead of flipping coins to make bets based on short-term headlines, those who can identify underlying value during a market sell-off sees this as an opportunity.

Value investors see falling stock prices simply as companies on sale. The lower the price the better. This requires patience, but if a company is truly undervalued then eventually the stock price should reflect its underlying enterprise value.

This does not mean to buy and hold forever, which has underperformed actively managed portfolios for over a decade. All investments should be regularly evaluated. The point is only that headline risk, unless it directly relates to a company's intrinsic value, is considered mostly noise to long-term investors.

Position traders and long-term value investors have four key advantages over short-term momentum traders who are subject to headline risk.

  1. They focus on home runs instead of base hits. Lower stock prices mean more shares & leveraged returns for the same money invested.
  2. They are patient and don't commit all at once. If the stock goes up they win now, and if down they can add more at even lower prices.
  3. They base investment decisions on reasonable company values, not on the stock market's unpredictable & irrational momentary mood.
  4. They not only have time, value and leverage on their side; generally the more something is undervalued, the higher the potential return.

Where are we looking for value right now?

Definitely not bonds which we haven't liked for a few years. For us they remain a risky cash parking spot with virtually no upside. Fully taxable coupon interest is at historic lows, many at near 0%, with substantial capital loss downside risk if interest rates rise suddenly. Default risk used to concern mainly corporate bondholders, but today some sovereign government bonds looks just as junky. A near guaranteed lose-lose - the money mattress looks better.

For regular cash-flow I'd prefer the many utility stocks that yield more than 10-year Treasuries. Look at (NYSE: T) AT&T on dips, currently paying a dividend of almost 6%.

For growth and diversification, I believe the theme of having some commodities and stocks that explore, develop and produce these hard assets remains solid. We believe gold and silver are in the middle innings of a 20-year uptrend. The contrarian in us also likes beaten up natural gas and diamond plays that have an established resource, for a turnaround sometime over the next year.

However the most compelling short, near and long-term story may again be uranium stocks. This time last year uranium stocks were the hottest stocks in the hot energy sector. This all changed in March after Japan's earthquakes, tsunami and the Fukushima nuclear plant accident.

Instead of recovering, uranium stocks have been slammed even lower recently in sympathy with the stock market's general weakness.

How can we spot value in specific resource stocks?

Another way of looking for value is to compare a resource company's market capitalization to the value of its resources and cash, less any debt. Take for example one of our featured stocks (Amex/TSX: URZ) Uranerz Energy.

Uranerz has sold-off hard recently with the rest of the market and its current market cap is now down to US$ 146 million. The company has over 19 million pounds of U3O8 in the measured, indicated and inferred categories. These NI 43-101 compliant resources are from only 7 of over 30 uranium projects they have in the prolific Powder River Basin, Wyoming USA.

The company recently started construction of its first ISR uranium mine at their Nichols Ranch project. Uranerz expects the mine to cost US$ 35 million and anticipates production to commence later next year. They currently have over $40 million cash in their treasury with no debt.

Last year some uranium deals were done at over $12 per pound in the ground. The takeover valuation for Mantra Resources by ARMZ/(TSX: UUU) Uranium One was at $9.50 per pound.

Rough math of 19 million pounds at $9.50 to $12 could put Uranerz Energy's enterprise value somewhere around $180 to $228 million. This does not include the company's cash or especially the potential of their other 23 projects.

URZ' closing trade today was at US$ 1.90 per share. If you take the company's current market cap of $146 million and subtract the $40 million cash, the market is currently assigning an enterprise value for the company of only around $106 million.

Another way of looking at this is that $106 million equates to only $5.58 per pound of proven in-situ uranium resources, so far. Produced Uranium is currently trading at over $54 per pound.

Has uranium put in its bottom?

An obvious sign of a resource market bottom is when major producers start aggressively buying up companies.

On August 27, 2011 the Globe & Mail published a report entitled "Cameco puts up hostile offer for Hathor". The tagline reads, "The $520-million all-cash bid could spark a bidding war for the Saskatchewan-focused explorer".

Snippets mention that:
  • "The offer could also reignite deal activity in the sector with companies such as Hathor's Saskatchewan neighbour (TSXV: FIS) Fission Energy."
  • "Cameco is counting on uranium prices to bounce back through strong demand from countries such as China and India."

The article also mentions that (TSX: CCO)(NYSE: CCJ) Cameco Corp. paid $498 million in 1998 for Uranerz Exploration and Mining Ltd. - the third largest uranium producer in the world at the time and it was run by some of the same people behind the current (Amex/TSX: URZ) Uranerz Energy.

(TSX: HAT) Hathor Exploration's board has rejected the offer on the basis that it is predatory, fails to recognize strategic value, carries an inadequate premium, ignores other assets and that the offer is highly conditional.

Hot off the presses this morning, October 19, another major miner (NYSE: RIO) Rio Tinto has just topped Cameco's unsolicited C$3.75 per share offer with its own all-cash offer of C$4.15 per Hathor share, equal to C$578 million on a fully diluted basis. The new offer is more than 55% higher than Hathor's C$2.67 closing share price on August 25th and is 11% higher than Cameco's offer.

Hathor's board has unanimously recommended that shareholders accept the Rito Tinto offer. Senior management have entered into lock-up agreements and have agreed to tender their shares. However the market may be suggesting that even with management's support, the bidding may have just begun. Hathor's shares closed today at $4.40 +$0.37 +9.18% on almost 14 million shares traded - already 6% higher than the latest bid.

This story is far from over and perhaps in a few months we will look back at Cameco's offer for Hathor as the Starter's Pistol of the next uranium bull market.

Even more signs of a bottom for uranium

How much worse could the uranium market get? Are we at the moment of optimum pessimism?
  • Japan was hit with its worst earthquake and tsunami ever, triggering the worst nuclear accident since the 1986 Chernobyl disaster
  • Nuclear programs around the world were placed under review that will result in improvements in safety
  • Germany announced plans to exit nuclear power generation by 2022
  • Italy cancelled plans to build 10 new reactors
  • Switzerland cancelled plans to build new and replace 5 old reactors

In the aftermath of all of this bad news, that severely punished virtually any uranium related investment, fundamentally the world remains committed to nuclear power despite the headline risk!

China is the big player in future nuclear power plant construction. In August they completed safety inspections of all plants a month ahead of schedule. Some believe nuclear power plant approvals may soon resume.

China is still building reactors and the Ningde nuclear power plant is good example of China's commitment to nuclear power. The reactor building's dome was recently installed 80-days ahead of schedule.

To reduce dependence on imported energy, the Czech Republic now plans to up its nuclear power generation to supply 60-80% of its electrical needs by 2060.

Finland's supreme court ruled in favour of a nuclear reactor project, and in July their parliament voted for constructing 2 new nuclear reactors, to total 7. Finland has high energy demands during harsh winters, and their steel making, forestry and other industries all rely on low cost power.

After Germany shut down 8 of 17 nuclear plants, they have been importing massive amounts of nuclear energy from France. German utilities have asked for one reactor to be put back online to avoid blackouts that could be the worst since WWII during a severe winter. Germany's emotional plan to replace nuclear energy with renewable energy by 2019 is not practical. Nuclear energy provides 25% of their power and eventually they may have to change back.

Even Switzerland seems poised to soften its adverse nuclear policy. Instead of a full ban after Fukushima on all new reactors, they are now considering next generation designs that include enhanced safety features.

Lastly, Japanese Prime Minister Yoshihiko Noda has stated it's "impossible" for Japan to get by economically without nuclear power or under a quick phase out plan. A power shortage "could bring down Japan's economy".

Replacing nuclear power with coal, LNG, oil or other conventional energy sources is prohibitively expensive. Switching to alternative energy sources such as solar, wind and geothermal is expensive and impractical, requiring a 49-fold increase in current capacity.

Only 11 of Japan's 54 nuclear power reactors are currently in operation. Noda intends to restart Japan's idled reactors over the spring and summer 2012.

How many more signs of a bottom for uranium are needed?

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