From Matthew Partridge, across the river from the City
It's a bad time to be a metal miner.
A few years ago, mining stocks were all the rage.
All the talk was about the euro crisis and quantitative easing (QE) leading to inflation. Most observers thought that Chinese growth would continue to generate a huge demand for industrial metals.
Fast-forward to the present day and things have changed a lot. The big worry is now the threat of deflation. Meanwhile, the Chinese growth machine is slowing down.
This has been a disaster for the big mining firms like Rio Tinto and Anglo-American. Indeed, Rio's share price is down a third from its peak in 2011.
So is this the time to pick up a few bargains – and if so, which commodities and firms look most promising?
The latest issue of MoneyWeek magazine is out now
Inside this week’s issue:
Faster and faster... The frenzied pace of the high-tech revolution
Other featured stories:
● David Cameron defies Brussels
● The death of the supermarket
● Victoria Beckham's £200m fashion fortune
For immediate access to the most up-to-date MoneyWeek news and articles please download your copy here.
If you’re not already a subscriber, click here to receive four FREE issues
Shock and ore
One of the worst performing commodities has been iron ore – its price has fallen by 40% since the start of the year and nearly 60% since its peak in 2011.
One of the main reasons for this is the slowing Chinese economy. Indeed, the latest results suggest that growth is now barely above 7%, the lowest in 24 years. Some experts think that it could fall to as low as 6% in the near future.
The Chinese government is also trying to move the economy away from export and investment driven growth. Instead, it is trying to foster the creation of a middle class that will save less and consume more. This should reduce the need for heavy machinery and large building projects, both of which require high levels of steel. In turn, this should reduce the demand for industrial raw materials, such as iron ore.
However, the good news is that the Chinese government is still investing in infrastructure. For instance, it is spending over $117bn on its rail infrastructure this year alone. All these new rail lines and trains will require large amounts of steel. As a result, Chinese steel production is still rising, though at a much slower rate than before.
One of the big features of the mining industry is that it tends to go in cycles.
The cycle starts with a sudden increase in demand. Because it takes time to increase production, this leads to higher prices. In the short run, these higher prices lead to bigger profits. Over time, this leads them to invest more money both to expand existing mines, and find new hidden deposits. Eventually, this leads to a bigger supply, pushing prices down.
In reality, the industry tends to overshoot on both sides. This means that during boom times, every project that looks even half-decent, and many that don't, gets approved. This means that after a short while, you end up with a glut. Then, when prices start to fall, firms tend to go to the other extreme. Capital expenditure is cut to the bone and even sensible projects that have the potential to make a lot of money are scrapped. This helps prices to bounce back.
For the past two years, the mining industry has been in full-scale cutting mode. Indeed, since 2012, capital expenditure by the ten largest firms has fallen by a fifth.
Iron ore mines particularly have closed down completely. Indeed, Caroline Bain of Capital Economics notes that higher cost iron ore producers in countries like Iran and Malaysia have gone out of business. Last month, Western Desert Resources, an Australian producer, filed for bankruptcy.
While this is bad news for those who work in the industry, there is hope that in the near future, production will start to fall, pushing up prices for mining firms that remain.
Time to buy Rio
One mining firm that we like is Rio Tinto (LSE: RIO). While it also mines other metals, including copper and aluminium, it gets around half its earnings from iron ore. However, the fall in the price of iron ore hasn't hit its profits too badly, because it is one of the lowest cost producers.
At the same time, it stands to benefit from any rebound in iron ore prices. This is because it has very large reserves. Indeed, it has said that it has the potential to ramp up production by a large amount without much additional capital expenditure or new exploration, which would normally be a big drag on cash flow.
Already there is talk that its strong balance sheet and efficiency make it an attractive target for one of its rivals. Indeed, earlier this month, Glencore confirmed that it had spoken to Rio's management about a merger in August. While this offer was rebuffed, JP Morgan believes that Glencore could make another offer – one that was possibly at a big premium to Rio's current share price.
Even if it isn't approached, Rio's valuation is very attractive. It currently trades at only 9.3 times current earnings, with a very solid dividend of over 4%. JP Morgan thinks that if you value potential projects at current prices, it should be worth £40 – which means that it is undervalued by around 25%.
Got a comment on this article? Leave a comment on the MoneyWeek website, here.
Senior Writer, MoneyWeek
Share this article today:
Our recommended articles for today…
The other reason dividends are so important
- Investment theory holds that dividends don't matter. But as David Thornton explains, nothing could be further from the truth: The other reason dividends are so important
An exciting future for tech stocks
- We live in a golden age of unprecedented technological change. Smart investors should get in early, says Jim Mellon: An exciting future for tech stocks
This day in history
31 October 1956: Britain and France bomb Egypt
On this day in 1956, Egypt came under bombardment from British and French planes, as part of a larger operation to retake the Suez Canal. Read more here.
And for yesterday’s market update, see below...
This gold pattern has an urgent message...
Have you got any gold in your portfolio? If you have, congratulations - one gold expert thinks you’re in line for a highly profitable 2014.
His optimism is based on one unbroken pattern he’s uncovered in the gold market - and he’s got over 50% of his capital in one niche investment that he thinks is set to dwarf the metal’s potential climb...
Click here to find out what he’s banking on
Metals and Miners is a regulated product issued by Fleet Street Publications Ltd. Your capital is at risk when you invest in shares, never risk more than you can afford to lose. Forecasts are not a reliable indicator of future results. Please seek independent financial advice if necessary. Fleet Street Publications Ltd. 0207 633 3600.
Click here for the latest stock market news and charts.
The FTSE 100 rose for a second day yesterday, rising ten points to 6,464.
Wealth manager St James’s Place topped the index with a gain of 3.6%, while Smith & Nephew, a maker of medical devices, followed closely behind, adding 3.5%.
However, mining stocks crowded the bottom of the FTSE 100. Randgold Resources was the biggest faller of the day, losing 6.0%. And Fresnillo and Anglo American fell 4.3% and 2.4%, while Glencore was down 2.0%.
In Europe, the Paris CAC 40 rose 30 points to 4,141, and the German Xetra Dax gained 32 points to 9,115.
In the US, the Dow Jones Industrial Average gained 1.3% to 17,195, the S&P 500 added 0.6% to 1,995, and the Nasdaq Composite was 0.4% higher at 4,566.
Overnight in Asia, Japan's Nikkei 225 rose 4.8% to 16,414, and the broader Topix index gained 4.3% to 1,334. And in China, the Shanghai Composite gained 1.2% to 2,420, and the CSI 300 added 1.6% to 2,508.
Brent spot was trading at $85.51 early today, and in New York, crude oil was at $80.61. Spot gold was trading at $1,175 an ounce, silver was at $16.03 and platinum was at $1,234.
In the forex markets this morning, sterling was trading against the US dollar at 1.5986 and against the euro at 1.2719. The dollar was trading at 0.7957 against the euro and 111.44 against the Japanese yen.
And in the UK, International Airlines Group (IAG) has upgraded its profit forecast. The owner of British Airways reported better-than-expected third-quarter operating profit of £708m, a rise of around 30%. The airlines group is widely expected to issue its first dividend.
This Microportal is built on the 2day Microportals platform which provides you with 3 click access to local and global information crucial both to your personal and working life. The platform provides live local data on transport, what's on, accommodation, eating out, shopping, sport, religion and weather as well as comprehensive reference and resource sections including TV, radio, online shopping, route planning, health, education and more.
Copyright © 2004–2014 2day Microportals, East Quither Farm, Milton Abbot, Tavistock, Devon, PL19 0PZ, UK.