Stock in Focus Portfolio: Will Pan African Resources deliver golden returns?

This year’s rebound in the gold market has an authentic feel, in my view. The gold downturn started much earlier than the slump in the oil and the general mining downturn.

Until a few months ago, gold mining stocks had been out of favour for some time. That situation now seems to be changing.

Gold miners that worked hard to cut costs during the downturn are now starting to reap rewards. While I’ve been writing this article, gold touched $1,300 per ounce. That’s a 22% rise so far this year.

While I’m not sure how long gold’s momentum will last, the evidence suggests that gold has now bottomed out and entered a new upcycle.

Gold miners rebounding

Shares in many gold miners have already risen by 50-100% this year. This week’s portfolio selection, Pan African Resources, is no exception. At the time of writing, these shares have risen by 92% so far this year. Yet unlike some of its peers, Pan African still looks good value.

The stock trades on a low forecast P/E with a generous yield. Pan African also benefits from a decent level of analyst coverage, which should help us to form a more meaningful opinion about the near-term outlook.

Pan African Resources’ StockRank of 98 means that it has risen to the top of the Stock in Focus portfolio screen this week, and will be the next addition to the SIF portfolio.

This could be a controversial choice and it’s certainly not without risk, as I’ll explain later. But now could be a good time to get back into the gold market, and I believe that Pan African could have the potential to deliver attractive returns for shareholders.

Deceptively good value?

A cyclical stock coming out of a deep downturn often looks expensive on a trailing P/E basis. According to Stockopedia, Pan African trades on a trailing twelve month P/E of 15.6 and on a 2015 historic P/E of 20.7.

I’m not too concerned by this, given the improving outlook. I’m also encouraged by Pan African’s other ValueRank metrics. The stock has a trailing dividend yield of 3.7% and an earnings yield of 9.3%.

The only real concern is that free cash flow was apparently negative last year. However, closer inspection suggests this is the result of an accounting quirk. Like Laura Ashley, Pan African includes dividend payments in the operating cash flow section of its cash flow statements.

This means that dividend payments are deducted before free cash flow is calculated (free cash flow = operating cash flow minus investing cash flow). Since dividends are normally paid from free cash flow, this seems illogical to me. Here’s an example from the firm’s latest interim accounts:

If dividends were accounted for in the normal way, I estimate that the dividend would have been covered by free cash flow last year, excluding acquisitions.

A cut above the rest?

Pan African scores highly for quality, with a QualityRank of 95. A look at the QualityRank breakdown shows several obvious reasons for this.

First up is a Piotroski F-Score of 8 out of a possible 9. This score is heavily weighted in the QualityRank calculation and has also become one of my own favourite metrics. It provides a useful snapshot of profitability, liquidity and cash flow. If you haven’t investigated the F-Score before, I’d highly recommend it. You can get a detailed breakdown for any stock by clicking on the Piotroski F-Score link on the Stock Report page:

Another big plus is that unlike many miners, Pan African has a consistent history of being profitable! The firm’s five-year net average margin is 21.7%. Although profit margins did fall in 2014 and 2015, results for the first half of the current year suggest margins are now rising again:

I’ve already discussed the Pan African’s cash flow so won’t reiterate that here. The only additional point I’d make is that the firm maintained a net cash balance from at least 2010 until last year, when a modest amount of debt was drawn down to finance various acquisitions.

Momentum

Pan African has blistering momentum at the moment. A MomentumRank of 99 provides some clue to this and is the result of strong price and earnings momentum.

Obviously it’s not possible to tell when the current surge in gold and gold stocks will start to moderate. But in my view Pan African’s momentum metrics do suggest that the stock has both short and medium-term momentum:

Earnings estimates have been upgraded by 13% for the current year over the last three months. This is largely the result of the price of gold romping higher. Next year’s earnings forecasts have also been tweaked up.

The shares now trade on a current year forecast P/E of 8.4, falling to a P/E of 6.5 for 2016/17. There’s a forecast yield of 4.8% for the current year, rising to 5.2% next year.

If Pan African can deliver on these forecasts without compromising its balance sheet, then I’d hope that these valuations might improve.

Interestingly, Pan African delivered a 20% earnings surprise during the final six months of 2015, when the gold price was much lower and quite volatile. This suggests to me that the company could perform well in a flatter market.

What could go wrong?

I mentioned earlier that Pan African carried certain risks. One of these is simply that the firm operates in South Africa. While Pan African appears to have made good progress with wage negotiations, as part of the local ownership requirements for its mines, this area is a moving feast. In my view it remains a risk.

A second concern is that currency effects could make it hard to monitor the firm’s progress. Pan African effectively works in three currencies. Most costs and gold sales are in South African Rand, but gold is sold based on its US dollar market price. The rand has weakened against the dollar over the last year, which has helped South African miners. But this trend could reverse.

A further complication is that Pan African’s reporting currency is the pound. We also need to consider the strength of the pound against both the dollar and the rand when interpreting the group’s results.

Finally, Pan African is listed on AIM. Solid companies shouldn’t be penalised for listing on AIM, but they are. Paul Scott highlighted this issue in Tuesday’s SCVR.

Bold or rash?

My experience suggests that mining stocks are not always popular with Stockopedia subscribers. Adding a gold stock to the SIF portfolio could be a mistake. I may also be too late to catch the bulk of the gains.

However, Pan African is a stock I’ve been watching for some time. I believe it’s a well run, profitable miner with good long-term income potential and a reasonable valuation. For these reasons, it’s now in the portfolio.

Disclosure: Roland owns shares of Laura Ashley.