Its hard to imagine a broader brush approach to commodity investing than investing in the mega-sized mining companies such as Rio Tinto (LSE: RIO), BHP Billiton (LSE: BLT) and Anglo American (LSE: AAL).
If we pile into these firms shares now, we are calling the bottom for major commodities such as iron ore, copper, oil and coal. By investing, we are saying, commodity prices are staying where they are or going up from here; they are not falling further. Right?
Plunging commodity prices
To be wrong on that point could be disastrous for shareholders. Its possible for still-plunging commodity prices to wipe out profits altogether for the big miners. If that happens, we can be certain that miners share prices and dividend payments will follow.
Already the big mining firms are engaged in frantic cost-cutting measures after input expenses spiralled up out of control in the so-called super-cycle speculative bubble. They are also ramping up production in an attempt to maintain profits. Such an apparent dash for market share, which sees them working harder for less return, will be unsustainable if prices drop too far, and they might.
Take iron ore, for example. Rio Tinto earns around 85% of its profits from the raw material, BHP Billiton about 45% and Anglo American near 30%. Since peaking around February 2011, the price of iron ore plunged and now sits around 67% lower.
We must look back six years to see the base metal trading around current prices. Admittedly, the price bounced back a little from its low earlier in 2015, but remains almost four times higher than it was in January 2005. Back then, and for decades previously, price fluctuations were far less dramatic.
Even allowing for price inflation, iron ore could have much further to fall to revert to a more normal trading range. A similar story exists with other commodities.
When will the downtrend end?
No one knows when the downtrend for commodity prices and miners share prices will end. However, once it has ended we will find clues in the charts to tell us so. Id argue that a broad-brush approach to commodity investment, such as buying big mining shares, requires some form of confirmation that the down trend is over.
Charts seem important for this kind of broad-brush approach to investing because they measure sentiment. Flat-lining price charts across many different commodities and mining shares would be a strong clue that price conditions in the sector have bottomed. We might want to see such stable prices for a few months to allow the big mining firms to adjust to the new environment operationally. After that, when, and if, commodity prices rise again, a series of higher lows on the chart could suggest a new uptrend.
Until we see these conditions on the charts, dividend yields are no safety net, because the miners profits may not be able to sustain the payout when their output prices keep falling. Investing in the big miners now looks more like gambling than investing, to me. My guess is that its way too soon to buy the big miners such as BHP Billiton, Rio Tinto and Anglo American. Markets tend to move much further than we imagine in either direction. We should wait for confirmation of a trend change before even thinking about buying.
Instead, I’m looking at firms likely to benefit from lower commodity prices such as thesebusinesses with strong trading franchises. You can find out why the Motley Fool’s analysts rate these firms so highly by clicking herefor our special free report, 5 Shares To Retire On.
Kevin Godbold 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.