reasons to start buying mining stocks

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Invast Insights Week Commencing October 21, 2013

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This Invast Insights report last October 21, 2013 explained why it may be time to start buying mining stocks. We also shared which stocks were worth buying based on our table data last October 17, 2013 and our initial impressions on the Telstra AGM and their growth forecast.

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Invast Insights

Week Commencing October 21, 2013

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www.invast.com.au | 1800 468 278

This week we look at the following topics:

1.0 Why it may be time to start buying mining stocks

1.1 Reasons to start buying mining stocks

1.2 The future of China’s railways

1.3 Rio Tinto deserves a pat on the back

1.4 Which stocks are worth buying?

2.0 Initial impressions on the Telstra AGM

3.0 Revisiting the 15 hidden gems

4.0 September jobs report new release date

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1.0 Why it may be time to start buying mining stocks

One of the best ways to have blown money over the past two years would

have been through buying and holding Australian resource and mining

companies. It’s been a disaster with the exception of a few large names like

BHP and Woodside Petroleum (which we hold in our wealth preservation

portfolio). There has been huge value destruction in small to mid tier mining

companies over that period, mainly due to the slowdown in the pace of

Chinese consumption. It’s not that Chinese demand has completely

evaporated but instead the huge investment into infrastructure post 2009

was not replicated in 2012-2013. China is finally starting to increase its rate of

minerals consumption and the iron ore price has been a great example of the

ongoing demand picture. We’ve discussed our view on China in prior reports.

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There is an age old Chinese proverb that goes along the lines of “don’t try to catch a falling knife”. The relevance to markets is that it is always extremely difficult to pick an upturn in a particular stock or sector after it has been battered. The economists will still caution against buying mining companies but we know that economists and most market analysts are always behind the curve, moving their estimates after the horse has bolted. We think mining stocks are about to turn on the Australian stock market for the reasons outlined below.

Before you continue reading on, please take into consideration the fact that we might have our timing wrong. Any investment in mining stocks needs to have at least a three to five year time horizon. Most of the stocks have been decimated in terms of their share prices and valuations. Private equity is yet to pounce, merger and acquisition activity is still dead and most directors are yet to start aggressively buying their own shares. A very well-respected stock broking colleague, who specialises in the mining and resource space and someone who at the height of the market was earning seven figure salaries, recently told us that he is barely earning minimum salary. Meanwhile, clients who have been buying mining stocks from their stock brokers are probably sitting on steep losses.

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1.1 Reasons to start buying mining stocks

Supply is struggling - Copper producer Oz Minerals (OZL) disappointed the

market when it recently released its quarterly production report. While most

of the discussion was around how poorly the miner has performed, our

interest was more around the trends within copper mining.

Oz Minerals owns the Prominent Hill mine which is located 650km North West

of Adelaide in South Australia. It is perhaps one of the most attractive

geographies for mining – an open pit mine, a newly developed underground

mine, access to railway and low sovereign risk. The mine was first discovered

in 2001 and has been in production since early 2009. Oz Minerals has spent

many years and plenty of cash to get the mine up and running but over the

past year the rate of production has fallen from above 1000,000 of contained

copper down to around 70,000-75,000 tonnes this year.

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It is very important to get the full scope of Oz Minerals’ operations – please

watch the following corporate video to get an idea of the scope of the mining

operations and growth plans already in place. We aren’t talking about an

insignificant copper producer at all. This business matters. The problems Oz

Minerals are seeing in its production capacity are consistent with what others

are reporting in the industry. Press the Ctrl key on your keyboard and click on

the image to the left of this text to open the video.

Our rationale is that if a world-class deposit like Prominent Hill located in

Australia is struggling to grow production, the ability of new copper over the

next few years to fill the growing demand picture will see spot price

appreciation. Emerging copper producer Discovery Metals (DML) which set an

ambitious goal of becoming the next Australian mid tier producer out of

Botswana has seen its share price fall from a 52 week high of $1.76 to $0.06 as

of the time of writing. Discovery had been the talk of the industry as it

ramped up into production from development, even attracting a takeover

offer from Hong Kong based Cathay Pacific Group which its board rejected.

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Today, the business is struggling for survival, at the mercy of its banks as

lower copper prices and production problems have caused a cash crunch.

Even in the gold space, large producers like Newcrest Mining (NCM) have

issued several rounds of production downgrades and rising costs, eating into

their margins. We spoke about Newcrest Mining and the gold price in our

Invast Insights report published on 30 September 2013. Rio Tinto recently

reported solid growth in its Escondida copper mine but this has come after

several years of disappointment and huge amounts of capital expenditure. We

think the copper price is bound for a breakout before the year’s end as

stockpiles are drawn down and the supply side continues to weigh on market

fundamentals. When copper moves, all other industrial commodities take the

same direction. A US$4/lb copper price is not out of the question by the end

of 2015 from US$3.25/lb or thereabouts currently.

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* Mining stocks have cash – Not all, but some are starting to build their

coffers. Take another Australia mining company – Mount Gibson Iron (MGX).

The stock halved in share price value between February and April this year.

The reason you might ask? Stock broking analysts and investment banks

reduced their outlook on the iron ore price from around US$120 per tonne to

as low as US$85 per tonne and guess what? The iron ore price not only held

up above US$120 per tonne, but shot up to as high as US$150 per tonne.

Mount Gibson saw its stock price rise from a low of $0.405 in late June to

around $0.83 as of the time of writing. Investors and traders out in the market

realised that the forecasts were nonsense and valuations needed to be reset.

The most interesting point about Mount Gibson is that its cash balance grew

to $420m during the same quarter which saw its share price collapse then

recover. The business is on track to produce around 9-9.5m tonnes of iron ore.

Atlas Iron (AGO) is also in the iron ore space and comparable to Mount Gibson

in terms of production, sitting on around $120m in net cash when netting out

its debt obligations. Atlas has previously been aggressive on the merger and

acquisition front but a similar fate to its share price has seen a more conserva-

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tive approach in its growth. Once the market optimism returns, both these

businesses can put their cash to use and start spending on buying

competitors or developing their assets. The point here is that despite all the

fear and gloom, iron ore producers are sitting very comfortably in terms of

their balance sheets.

* Mining index continues to lag – The Materials Index (XMJ) has lagged by a

large amount relative to the ASX200 (XJO) and the Financials Index (XFJ) over

the past two years. The index is currently sitting at 9,706 points having

reached a high of 12,147 points in November 2011 and a low of 8,203 points in

June this year. The index was well above 15,000 points in April 2011. The chart

below shows the performance of all three indices over the past two years.

Charts have been taken from Invast’s share trading platform where the

advanced charting tool can be expanded to perform detailed analysis. The red

line indicates the Materials Index, green line the Financials Index and the blue

line the broader market as measured by the ASX200 Index.

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Image: Chart via Invast share trading platform – XJO, XMJ, XFJ indices as of 16 October 2013

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1.2 The future of China’s railways

During the September quarter, Brazilian iron ore giant Vale and Rio Tinto added over 40 million tonnes of annualised capacity into the market each while BHP and Fortescue Metals added around half that each also. The expectation was that iron ore prices would tumble under such extreme supply growth and guess what – the investment banking analysts were wrong again. The iron ore price has held up very well. In Invast Insights published on 16 September 2013, we spelled out our thoughts on China – basically remaining bullish. We said that steel production in China continues to charge ahead at an annualised rate of around 700 million tonnes per annum, growing year by year.

Most of the bears or skeptics out there focus on the rate of Chinese investment infrastructure with the odd attention seeker pointing to “ghost cities” where apparently nobody lives. This is a common excuse for being negative on China and negative on mining companies including iron ore stocks. At Invast we actually think that China will continue to invest

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aggressively in the years ahead, albeit very differently to the way it did in 2008-2010. One area which we think will underpin investment is the Chinese rail system and associated infrastructure.

There were some problems with the way investment was put into place very quickly between 2008-2010. We are not naïve enough to think that there weren’t any overcapacity issues. But in our view, China has learnt from these lessons and is ready to invest aggressively in large-scale investment which has the potential to provide solid financial returns and most importantly, social benefits to appease any political backlash. One of the best areas of investment is rail infrastructure for the following reasons.

• China already has one of the highest logistics costs in the world when measured relative to GDP. The investment into rail infrastructure has lagged other forms of transport on a relative basis over the past two decades even though it has grown in absolute terms. According to a report published by Armstrong & Associates, CSCMP & CLSA, logistics costs as a proportion of

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GDP two years ago in China stood at 18.1% compared to 8.5% in the USA and

8.3% in Germany respectively. We may think the Chinese have invested

enough in recent years through large infrastructure programs but there is still

huge scope for improvement in the railroad system.

• Speak to anybody who has recently visited a major city in China and they

will tell you that one of the major problems is the congestion in major

cities. There are more than 150 cities in China with a population greater

than one million citizens and this number will continue to grow as rural

residents migrate into major centres for jobs and education. We estimate

that around 15% of these cities have an adequate urban rail transit system

and most of these are only relatively new which means there is huge

scope for expansion.

• Rail investment is not just something which we have drawn up ourselves

because we felt like it, instead it actually features prominently in Beijing’s

long term reform plans. One of the first major reform measures adopted

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by the new Chinese leadership was to reform the Ministry of Railway into a

planning/regulatory arm and a operating arm now called the China Railway

Corporation.

We plan to go into more detail on Chinese rail infrastructure in future reports,

but for the time being the above goes some way to explain why steel

manufacturing capacity continues to grow in China and iron ore continues to

be consumed my steel mills as fast as it is being produced in Australia and

Brazil.

The investment banking analysts who only a few months ago were

forecasting iron ore prices to fall below US$100 per tonne are now slowly

revising their estimates higher. With all that in mind, we think the copper

price is next to move higher. In the meantime, you can watch our recent

interview with CNBC Capital Connections program, which touched on these

themes and other topics. Press the Ctrl key on your keyboard and click on the

image to the right of this text to open the video.

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1.3 Rio Tinto deserves a pat on the back

In addition to the above views, here is a summary of our initial impression on

the Rio Tinto quarterly production report which we published on the Invast

blog on 15 October 2013. Make sure you check the blog daily to see our

running commentary on the whole market and mining companies when

sensitive news breaks:

It has been a year of transition at Rio and the market has on aggregate been

skeptical - a new CEO, huge exposure to the iron ore price, Chinese growth in

question etc. But sometimes you need to sit back and congratulate a

company for delivering a very good set of numbers and in light of the

circumstances mentioned above, the third quarter trading update is exactly

that - a good set of numbers. There tends to also be a sense of renewed

optimism coming out of this report with Rio talking about its ability to push

its Pilbara assets, ahead of time and under budget.

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The highlights for us are obviously the growth in iron ore shipments and

production, up 4% and 2% respectively from the same period last year. The

iron ore price is holding up above A$140 per tonne which will bode well when

the earnings numbers are released in February. Copper is also the big

standout and shouldn't be ignored, up 23% on the back of disruptions last

year and significant capital expenditure at Escondida.

Bottom line: Rio is current trading on around 11x next year's consensus

earnings numbers. There is large scope for upside in these earnings estimates

which have already factored in some turnaround, but not the full extent that

this report card suggests. If Rio continues to report solid numbers, cut costs

and benefits from an improvement in iron ore and copper prices - the latter

yet to materialise - then it can easily see its share-price with an 8 in-front of it.

Invast sees the mining and resource stocks shifting in investor preference and

likely to outperform the broader share market over the next twelve months.

We're ringing the bell and Rio provides us with very good reason to do so.

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1.4 Which stocks we think are worth buying?

There is no shortage of mining stocks promising the world on the Australian

market. Anybody can put together a glossy presentation and talk up their

prospects but in this environment one thing is vital – cash. If our time horizon

is three to five years, you need to be in businesses which have leverage to

earnings growth but enough resources to ride out the downturn in case we

are wrong. The following stocks are top of our list but please keep in mind –

perhaps sounding like a broken record here – your time horizon needs to be

at least three years. There is a chance that we have our timing wrong, but our

underlying thesis is unlikely to change.

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*Table data as of 17 October 2013 – source Invast Share trading platform.

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2.0Initial impressions on the Telstra’s AGM

There are three certainties in life - death, taxes and David Thodey's commitment to dividend payments for Telstra shareholders. Today's AGM does not provide any real new news but it does dash any nerves that were out there in the market about Telstra's earnings, the new government in Australia and the NBN process. Telstra says the NBN is under review but is working towards its own agreement terms - for the time being there does not seem to be anything detrimental to the company. Perhaps a little more information would have gone done well with the market, but the nature of these things can often limit what a public company says.

The market was perhaps looking a lot closer to guidance to see if there would be any changes. Going into 2014, there have been some analysts out there with rosy growth assumptions underpinning an argument for dividend growth. Telstra says it is forecasting low single digit total income and EBITDA growth with free cash flow of $4.6- $5.1bn. This is in line with guidance provided at the result release in August.

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Bottom line: There is nothing new coming out of the Telstra AGM, but

sometimes that's exactly what the market wants to hear. Thodey is working

hard to steady the ship and he knows that volatility in earnings is not

something his shareholder base will tolerate. We think 30 cents per share

dividend payout in 2014 - as forecast by many analysts and consensus - is too

high and the number will come in line with that of 2013. Even still, a 28 cent

per share fully franked dividend is not a bad outcome at all given low cash

rates, but it does limit Telstra's ability to continue rallying. It should be a core

portfolio holding for the conservative investor, but unlikely to be an

investment which will shoot the lights out.

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3.0 Revisiting the 15 hidden gems

In our first published Invast Insights report dated 26 August 2013, we

published a list of 15 hidden gems we thought were worth adding to your

watch list. We made the point that not all of the stocks were buys but all of

them deserved to be on a stock watch list for various reasons. We take this

opportunity to review the list and report the performance on each stock. The

data shows that our winners were much larger than our losers – the best gain

was in software developed Praemium (PPS) which gained 52.6% in the two

months since publishing our report. The worst performer? Vision Eye Institute

down 10% as of the time of writing but a stock we have full confidence in and

something we followed up in prior reports. The lesson here is that it is ok to

have losers in your portfolios but the winners need to more than make up for

any loss – exactly the case we see in our 15 hidden gems. Our best winner is

five times greater than our worst loser. We can live with that.

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Here is the complete list and their performance results over the timeframe.

* Table data as of 17 October 2013 – source Invast Share trading platform. IMF

performance depends on participation in share purchase plan.

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Even though we didn’t rate all of these stocks as a buy, if for example one was

to have purchased $10,000 in each of the 15 stocks – the portfolio would have

returned $17,336 over the past two months or around 11.6%. Not bad

considering markets have barely gone anywhere over the past two months

while the US debt crisis has crippled markets, weighed on sentiment and

driven up volatility.

IMF has been one of the worst performers of the list but it’s worth noting the

business announced a capital raising which has seen its share price fall. New

shares were offered at $1.70 to institutional shareholders and a share

purchase plan is open to ordinary shareholders at $1.70 a share for up to

$6000 worth of shares. So under the above scenario, a $10,000 investment

and participation in the share purchase plan would bring down the average

purchase price closer to $1.86 which would be a total decline of 3.2%

compared to the 8.2% decline reported above. When we put the list together

we specifically excluded mining and energy stocks. We maintain that bias for

smaller companies.

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The list remains unchanged for the time being but we will review it in January

with the following stocks all contenders to make it to the list.

*Icar Asia (ICQ) – Often nicknames the next Carsales.com in Asia, this is a

business which has seen its share price rise by three times over the past year

and continuing to go higher as of the time of writing. The stock owns a

portfolio of automotive websites in Malaysia, Indonesia and Thailand as well

as an automotive magazine in Malaysia. Funnily enough, Carsales.com (CRZ)

has purchased 19.9% of the company – a move which some say underscores

the attractiveness of the business. We still need more convincing on the stock

but if results stack up by January, we will be including it in the list.

*Mobile Embrace (MBE) – We wrote about Mobile Embrace in Invast Insights

published on the 9th of September and 14 October. In our first report we

suggested this Telco as a great growth business and since then the share price

has more than doubled. We then suggested taking profits even as the share

price continues to run up. Like ICQ, we still need a little more convincing on

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the whole story, revenue and earnings are growing but so too have market

expectations and so there needs to be a period of consolidation before we

add it to the gems list. It’s on the back of our minds but not the highest in

priority at the moment, we are pleased with our recommendation to get in

and then get out – banking profits for readers of this report.

4.0 September jobs report new release date

Because of the US government shutdown and debt ceiling problems, US jobs

numbers were not released on time and are now scheduled to hit the market

on Tuesday 22 October 2013. Consumer price index numbers will be released

on 30 October 2013 and producer prices on 29 October 2013. In its last

monthly employment report, the Labor Department said 169,000 jobs were

added to nonfarm payrolls in August and the unemployment rate was little

changed at 7.3%.

Visit our resources page and listen to daily trading updates via podcast.

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5.0 Disclaimer

Please note that you are receiving this report complimentary from Invast Financial Services Pty Ltd (AFSL 438 283). Invast staff members may from time to time purchase securities which are included in this or future reports. The authors of this report may or may not be holding a position in the securities mentioned. Please note that the information contained in this report and Invast's website is of a general nature only, and does not take into account your personal circumstances, financial situation or needs. You are strongly recommended to seek professional advice before opening an account with us.

General Disclaimer: This newsletter contains confidential information and is intended only for the person who downloaded it. You should not disseminate, distribute or copy this newsletter. Invast does not accept liability for any errors or omissions in the contents of this newsletter which arise as a result of downloading this newsletter. This newsletter is provided for informational purposes and should not be construed as a solicitation or offer to buy or sell any financial product. Invast Financial Services Pty Ltd is regulated by ASIC (AFSL 438 283 | ABN 48 162 400 035).

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Risk Warning: It's important for you to read and consider the relevant Product

Disclosure Statement, and any other relevant Invast Financial Services Pty Ltd

documents before you decide whether or not to acquire any financial

products listed in this email. Our Financial Services Guide contains details of

our fees and charges. All these documents are available here on our website,

or you can call us on +612 8036 7555. CFDs and Foreign Exchange are

leveraged products and carry a high level of risk and you can lose more than

your initial deposit so you should ensure CFD and Foreign Exchange trading

meets your personal circumstances.

General Advice Warning: Being general advice, this newsletter does not take

account of your objectives, financial situation or needs. Before acting on this

general advice you should therefore consider the appropriateness of the

advice having regard to your situation. We recommend you obtain financial,

legal and taxation advice before making any financial investment decision.

*Distributed with the permission of Invast.com.au