Sometimes, the biggest and most convincing-looking share price moves can be short-term reversals during a longer-term trend.
Theirprofits and share prices have been in down trend. Even after the shares recent bounce up, Rios share price is down 61% since 2011 and BHPs 73%. Profits collapsed over the period too, with both seeing declines around 70%.
Movements like that are enough to get the contrarian antennae twitching on investors who hope to buy low and profit from a recovery. However, Im ignoring such urges and avoiding big miners, because I think a return to past glories seems unlikely.
The challenge is their inherent cyclicality. Theyproduce a commodity product with little differentiation from other firms similar products. Worse, the selling price for theiroutput isnt set by themselves, but by the general market. That market price, for iron ore, oil and coal, is subject to the forces of supply and demand, and were currently seeing over-supply and weak demand bearing down relentlessly on prices.
Why iron ore is important
Rio Tinto earns more than 80% of its profits from producing iron ore and BHP Billiton about 45%. Since peaking during February 2011 at $187 dollars per metric ton, the price plummeted and now sits around 67% lower at $41. In December 2015, it was further down at $40 or so, but that bounce up is insignificant compared to the massive bubble in the price over the past 12years.
The trouble with iron ore at $41 now is that it was just $16 as recently as December 2004, and didnt top that level for the prior two decades. Historically, itsprice was stable for a long time.
Im not expecting another fast-inflating iron orebubble. Im no macroeconomic expert, but even Im aware that a keyconsumer of the stuff, China, is sitting on square miles of unused and unwanted property development and infrastructure. The growth figures for Chinas economy keep slipping, and in just about everywhere else in the world its proving hard for policy makers to keep the growth kettle boiling. What seems more likely, to me, is that iron ore could enter another decades-long stable phase. But at what price level? It could settle around $40, or evenlower. Even allowing for price inflation over the last 12 years, $40 is a lot higher than $16. It wouldnt surprise me to see the base metal slip below $30 dollars.
If a new, lower level is set to be normal for iron ore, Rio Tinto and BHP Billiton look over-valued. Todays 683p share price puts BHP on a forward price-to-earnings (P/E) rating of 31 for 2017. At 1,801p per share, Rio trades on a forward P/E rating of 14 for 2017. At those valuations, it looks like investors expect earnings to improve.
To me, cyclical firms such as the big miners, trading in a flat commodity price environment, would look more comfortable with P/E ratings around six or seven. On top of that expectation, I fear that iron ore, and the miners profits, may have further to fall before they settle. So I dont trust the recent bounce in Rios and BHPs share prices.
At some point, the big miners will look attractive. However, this is one of those investment plans that looks set to benefit from slothfulness. I want to see flat trading and flatlining charts measured in months oryears before venturing back into mining firms.
Kevin Godbold has no position in any shares mentioned. The Motley Fool UK has recommended Rio Tinto. We Fools don’t all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors.