2014 will be all about stock selection and pure alpha generation than chasing broader market indices. However, that does not mean investors should ignore macro and commodities entirely and continue to rerate equities without any evidence of a recovery. Mining stocks are a great example of this “blind faith” thesis. Mining Equities (SXPP) are up 7-10% year to date, whereas copper is down 4%, iron ore down 13% and most emerging market indices down ~ 7%. What gives?
Market participants have convinced themselves that we are in a new paradigm where commodity prices have no meaning for mining Equities. The latter should see P/E expansion based on cost cutting incentives, asset disposals, and higher free cash flow generation prospects. The mining companies are being prudent and cutting capex, paying decent dividends and do have the potential to return higher cash to shareholders in the next few years. Big round of applause to them. But what about price declines offsetting some of this strength?
Most recently, the new bull case seems to be “reflation” in which case mining equities are a buy. Wait, weren’t we just talking deflation less than a few weeks ago? This logic appears flawed as even CPI targets and prices have not breached any major levels yet.
Commodity stocks earnings are driven by their top line drivers, namely copper, iron ore, aluminium etc. If top line is down 10%, we will see earnings downgrades. Every asset class is discounting a slowdown in economic growth; commodity producing country foreign currencies are lower, commodities are down, even gold is up! Yet mining equities are defying gravity. I would agree to this line of reasoning if there was a serious case to be made for margin expansion and evident upgrades to come. We have not seen any.
Something’s gotta give?
Either the Commodity markets are wrong or the mining equities. I have seen this so many times when equity markets get ahead of themselves on “hopes” but after a few weeks when the underlying fundamenetal drivers do not budge, the hopes are dashed and trends converge again.
Commodity markets are behaving very sensibly. They are dictated by physical market balances and trends; there is ample inventory in iron ore and even copper despite supply outages. Demand is healthy but so is supply. If global growth really had picked up, why wouldn’t copper have moved higher? Iron ore prices have fallen from their peak in Dec’13 of $138/t to $120/t today. Usually Iron ore prices rally into a Chinese new year which is typically associated with restocking. The recent increase in Chinese port stocks to 97.5Mt (up 17% ytd) is noteworthy; not only does it reflect a significant increase relative to the 2013 average of 72.7Mt, but it also means that port stocks are at a level similar to the 1H 2012 average of 97.7Mt which preceded a destocking cycle later that year. Iron ore inventory levels at small and medium mills remain relatively low, but on balance the inventory position in China seems to be comfortable.
The sell side analysts are obsessed with Rio Tinto saying it is trading on “super cheap/trough” levels at P/E of 7.5-8x 2014/2015. Did the stock stop being “cheap” when it fell in 2012 as Iron ore prices collapsed? Mining stocks have always traded at a discount to NAV. That is not the debate. The important question is what level of discount is valid?
Iron ore can get to $100/t from $120/t today. For a 10% move in iron ore, Rio’s EPS gets hit by 15%! Even yesterday when it reported good numbers, 2014 guidance on copper and iron ore volumes were lowered by 6% and 4% respectively. It reported 2H13 FCF of $3.5bln equivalent to a 6.5% dividend yield; impressive but capital returns can only be unlocked in 2015, if everything goes to plan.
Rio Tinto is up 7% ytd whilst the Iron ore price is down 13%; would you be long here?
