Beware the ‘falling knife’

Have you seen the share prices of mining services companies recently? In most cases, you could be excused for reaching for the magnifying glass. The share price charts look like a ski run at Perisher or Hotham, and you’ll be able to tell mining services shareholders by looking at them – they’re the ones who look perennially punch-drunk.

The latest – and unfortunately probably not the last – example is Titan Energy Services (ASX: TTN) which lost around two-thirds of its value yesterday. The non-renewal of a couple of contracts saw the company’s shares fall hard.

From a boom to a whimper

The mining boom is well and truly over – at least in its investment and development phases. We’re still sending record volumes to China, whose appetite seems to be endless, but all of that business is being done by mining companies that already have mines in production.

If you’re an explorer, or a company that helps miners prospect, test or dig, you’re in a spot of bother.

The rollcall of suffering mining services companies (the aforementioned ‘helpers’) is long, and these were businesses that were flying high (and almost universally loved) in the good times. Those times are well and truly gone. Few, if any, new mines are being opened, and the ‘helpers’ are now fighting over the remaining scraps. There are a couple of bright (well, perhaps ‘less dim’) lights in the LNG business for those who’ve been able to secure contracts, but even that mightn’t last for long.

You see, once the overall volume of work in a given industry starts to dry up, the former fat cats who made astronomical profits in the good times turn suddenly and ferociously Darwinian. The falling number of projects mean less work to go around. Less work means less profit. Of course, less work also means the remaining mining services companies fight harder for what’s left, dropping prices (and margins) in the process.

Lower profit from less work, and lower profits still from skinnier profit margins on what work they can find. If you think that sounds like a tough way to make a living, you’re right.

Never say die… but know when to give up

But there are a good number of investors who won’t say die. They see low P/Es and falling share prices, and their bargain hunting gene comes to the fore.

“Surely they can’t fall further?” they say. “They’ve got contracted work for the next 12 months locked in.”. “They’re the best in the business.”

Quality is important. Low prices are attractive. Locked-in revenue is wonderful. But only if the industry economics stack up. Qantas (ASX: QAN) is a quality airline, fighting hard on price. There are no shortage of travellers, and our appetite for same is only increasing. And yet Qantas struggles to turn a buck. Why? Simply because the industry is characterised by excess capacity and significant fixed costs.

‘Best’ isn’t good enough

You can be the very best in the business, but if ‘the business’ is awful, there’s no point (and little benefit) in being the best.

There are two different types of falling knives. One is when a share price falls disproportionately to the prospects of a business. If you’re sure about the latter, the former is an opportunity, even if the ride is bumpy and hair-raising. But the second type of falling knife really will see you face the risk of losing fingers. It’s of the Billabong (ASX: BBG) variety.

Billabong — former market darling, and brand of choice for 30- and 40-somethings when we were kids – rose and rose, but then fell and kept falling. From over $12 in mid-2007, the shares started falling. Down 25% to $9. That enticed some. Then they lost 50% to $4.50. A bargain, surely. Losing 75% from there, the shares spent a little time at $1.20 – surely they couldn’t go any lower — then fell another 90% to just $0.11 per share.

Many investors either miss an opportunity to buy a great business because of temporary price falls. Others chase the prices of poor businesses down, and down, and down – never to recover.

Foolish takeaway

The lesson for investors is to focus not on the price activity, but the underlying economics of the business, and the future for both the company and its industry. It's entirely possible that some of the brave souls buying mining services companies will make money. There may well be stories of daring buys that turned into small fortunes.

Good luck to those investors - my guess is that they'll be dramatically outnumbered by bargain hunters that get their fingers burned.

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Scott Phillips is a Motley Fool investment advisor. You can follow Scott on Twitter @TMFGilla. The Motley Fool's purpose is to educate, amuse and enrich investors. This article contains general investment advice only (under AFSL 400691).

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