Are diamonds an investor's best friend?

The market seems to be stabilising

Updated: 
Diamonds

After a tough year for diamond producers, are things looking up? Shares of FTSE 250 miner Petra Diamonds (LSE: PDL) rose by more than 5% this morning, after the group announced a 30% rise in first-quarter production.

South Africa-based Petra and its small-cap peer Gem Diamonds (LSE: GMD) are working hard to take market share from sector heavyweight, De Beers. Both stocks look very affordable based on forecast earnings.

With the diamond market seeming to stabilise, is now the right time to buy into this sector?

A confident outlook?

Diamond production rose by 30% to 1,097,523 carats at Petra Diamonds during the three months to 30 September. The group received revenue of $94.7m during the period from the sale of 745,447 carats. Petra didn't hold a diamond tender during the same period last year, so there's no comparative figure.

Expansion programmes in the firm's Cullinan and Finsch mines remain on track, and are starting to deliver results. Based on today's figures, the group appears well positioned to hit broker forecasts for full-year sales of $576m.

Petra shares have risen by 64% over the last 12 months as diamond prices have recovered after production cuts by De Beers helped bring the market back into balance. Petra shares look decent value to me, on a forecast P/E of 10 and a prospective yield of 1.5%.

My one remaining concern is how quickly Petra will be able to reduce its debt levels. Net debt rose from $384m to $463m during Q1. The company says that this is within the expected range and that it should start to generate free cash flow during the second half of the current financial year. This implies that net debt should start to fall from January.

If it does, then Petra shares could still offer good value for growth investors. Earnings per share are expected to rise by 68% this year and by a further 50% in 2017/18. This puts the stock on a 2017/18 forecast P/E of just 7.

What about Gem Diamonds?

Petra's valuation depends on future growth. By contrast, Gem Diamonds' current valuation assumes that earnings will remain flat. That's why the stock is currently trading on a forecast P/E of 7 for both 2016 and 2017.

The group's short-term focus is on maximising cash generation and priority is being given to dividends. Shareholders should be rewarded with a 4% dividend yield this year. This dividend looks safe to me, given that Gem Diamonds ended the first half of 2016 with a net cash balance of $37m.

The downside of investing in Gem is that the growth potential of its Letseng and Ghaghoo mines appears more limited than those of Petra.

Is now the time to invest?

Diamond mining stocks aren't quite as cheap as they were one year ago. But I believe that both Gem Diamonds and Petra Diamonds have the potential to deliver decent returns for shareholders over the next few years.

Which stock is best may depend on your investing style. Growth investors are likely to opt for Petra, whereas contrarian value investors will probably be more attracted to Gem Diamonds.

Ultimately, it's your choice.

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Roland Head has no position in any shares mentioned. The Motley Fool UK has no position in any of the shares mentioned. We Fools don't all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.