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LONDON (Reuters) - Shares in diamond producers, which failed to join a mining sector rally last year as consumers shunned luxury, are set for a boost from a recovery in gem prices.
The diamond sector, a key supplier to the jewelry industry, was one of the hardest hit when consumers shied away from swanky purchases during the economic downturn amid worries about household debt, mortgages and jobs.
When prices of rough, or unpolished, diamonds dived in late 2008, stocks tracked the decline, but they have yet to fully react to output cutbacks by No. 1 producer De Beers and others that have nurtured a rebound in gem prices.
"The rough diamond market is recovering and prices are close to where they were prior to the downturn; the diamond stocks haven't reflected this yet, trading relatively flat over the past six months," said Tyler Broda, an analyst at Canaccord Adams.
"There was also no re-rating on the back of the better-than- expected Christmas numbers and the valuations still appear cheap. We think there is an opportunity here."
Investors seeking pure diamond exposure must look to mid- and smallcap stocks since the biggest producers are parts of diversified groups or unlisted like Russia's state-run Alrosa.
Around three-quarters of the London-listed diamond companies underperformed the wider UK mining index .FTNMX1770 in 2009, with a handful of firms, including Petra Diamonds (PDL.L) and Gem Diamonds (GEMD.L), seeing their value drop over the year.
Petra shed 24 percent last year, underperforming the UK mining index by 64 percent as most miners shot up, while Gem Diamonds lagged the index by 57 percent. The UK mining index doubled.
So far this year Petra has given up another 7 percent while Gem has gained almost 10 percent.
Exact timing is uncertain, but prospects are good for diamond stocks to outperform as higher diamond prices feed into company bottom lines and as the firms use new financing to build mines and boost output.
Analyst Des Kilalea at RBC Capital Markets advises buying firms that are already producing gems, rather than exploration companies that are still developing mines.
He said Petra was trading at about half of his fair value -- calculated using a multiple of net present value -- of over 100 pence and Gem Diamonds was at a 25 percent discount while major mining groups in the UK mining index were trading close to fair value.
"I think Petra is very cheap at the moment," he said, but added that Canada's Harry Winson Diamond Corp HW.TO was trading more in line with fair value.
Petra is expected to swing to a net profit of $21.7 million in its fiscal year to end June, according to Thomson Reuters I/B/E/S, from a net loss of $88.9 million the previous year.
It secured $120 million in financing in December, but its shares have been under pressure due to speculation of selling by major shareholder Saad Group of Saudi Arabia.
The strong outlook for diamond producers is also bolstered by the willingness of investors to provide finance in recent months not only to Petra but to Canadian-listed explorers Stornoway Diamond Corp (SWY.TO), Lucara Diamond Corp LUC.V and Rockwell Diamonds Inc. (RDI.TO).
Rough diamonds are not traded on futures exchanges, but prices probably tumbled about 60 percent during the downturn and have already recovered close to the previous peaks hit in early 2008, according to analyst Kilalea.
"I think definitely there is a much better outlook than we've had for quite some time," he said.
Prices got support when large diamond producers such as De Beers and Alrosa slashed output about a year ago.
Christmas sales in the United States, which makes up about half of the diamond jewelry market, were better than expected and demand for rough, or unpolished, diamonds was still buoyant, De Beers said on Thursday.
Rising demand from the jewelry market, the biggest source of revenue for the diamond producers, comes amid a rebound across the luxury goods sector after it suffered the worst industry slump in two decades.
Diamond prices, however, could be volatile in the near-term with the market digesting the impact of more supply as big producers such as De Beers and Alrosa ramp up production.
"I think (rough) prices could pull back a bit, I'm not looking for anything major," said Kilalea. "One hopes that the De Beers and Alrosa sales will be absorbed and I suspect they probably will."
Thanks to strong demand from Asia, analysts expect prices to be supported in the longer term, even after major producers restart idled operations.
"You have seen Chinese jewelry demand really pick up last year and this is adding a sort of balance to the market that wasn't there prior to the downturn," said Canaccord's Broda.
Evolution Securities said the supply side argument is the most compelling for diamond equity investment.
"Almost all industry participants believe that there is a looming shortfall of diamond supply against even the most modest demand forecasts," it said recently.
"Despite a boom in exploration in the last decade, there have been no new discoveries of any significance since the early 1990s and it is estimated that there is only 15 years worth of diamond production available in the world."
Editing by Sitaraman Shankar