Mining for a price recovery

PORTFOLIO POINT: Even a slowdown in global growth shouldn’t seriously dent demand for mineral commodities. BHP and Rio should be in line for a share price recovery.

Rising concerns over global growth and commodity demand and supply dynamics present a good opportunity to buy miners

To buy or not to buy? That is the question, or to sell if you’re a holder. There is certainly a growing disquiet about our miners and Tim Treadgold wrote a great piece last week on Rio Tinto capturing some of those concerns.

Many would argue that the issues extend beyond Rio however, and remain relevant regardless of the product mix. For instance, over the last week we’ve heard the Australian Treasury and others suggest that the terms of trade, or commodity prices more specifically, have already peaked. The federal resources minister, Martin Ferguson, suggested just over the weekend that the boom was done.

I for one am not as convinced, but it has to be accepted that this view is in the ascendency and perceptions matter. The question I’m left asking is whether these concerns present a good buying opportunity. In contrast, is it time to reduce resource holdings? At the end of the day, I think the answer must be no, and in my opinion it is currently a very good time to buy.

The issue for me is one of magnitude. I’m not suggesting concerns over global growth aren’t warranted and we got a reminder of the threat last week. Chinese trade data showed imports slowed to 6.3% y/y in June from 12.7% y/y, and Chinese growth more generally slowed to 7.6%. Concerns over global growth are legitimate. Although, as I have noted before, I remain very optimistic on growth prospects and think the evidence supporting a recovery is compelling. Seeing our miners come off a bit isn’t unreasonable then. But the magnitude of the price declines suggests to me that the market has lost some perspective.

For a start, I don’t think the prospects of our miners hinge on whether the global economy is staging a cyclical slowing or not – and, in particular, on whether China is slowing. I appreciate that this sounds counter intuitive and the fact BHP is down some 19% since a recent peak in February (Rio is down about 23% or so since its 2012 peak) shows the market disagrees. In fact if you’re bearish resources, everything appears consistent – global growth indicators are weakening, investment banks are cueing to downgrade growth forecasts and then commodity price forecasts more generally.

Chart 1: Resource commodity prices

Chart 1 shows graphically the bearish case. It’s the RBA’s non-rural commodity price index (of which coal and iron ore represent 53%, but it also includes aluminium, copper, crude, gold and LNG) and it’s down about 17% from a peak in August of last year (USD terms) and off about 5% since February (although in AUD terms it’s 1-2% higher since February).

Even if that is the case though, and we are past the peak, these 20% price falls for stocks like Rio and BHP appear a little excessive as they have given rise to forward earnings multiples of about 7-8 (for our large miners). Yet if we are to believe these are reasonable multiples (on a sustained basis,) we must be convinced of two things. One; that global growth will not just slow but slow sharply and two; that this slowdown will lead to a very serious hit to earnings – of up to 60% - on a sustained basis.

Table 1: Six year revenue profile of BHP and Rio

I’m just not convinced that we’re going to see this though. Take a look at table 1 above; even through the GFC, Rio and BHP’s revenue didn’t fall by 60%. I’m using revenue as it’s the purest form of underlying potential earnings derived from macro factors and is separate from more micro capital management issues and the like –such as the dilutive impact of Rio’s rights issue in 2009. So under a GFC type event we’re talking a 25% hit for Rio and about a 15% hit for BHP, which, even if that scenario were repeated, gives an implied price gain from current levels of something like 30% (given historical P/Es are in the mid-teens). To get even close to justifying current multiples, we would have to see a very serious global recession – one that went beyond what we saw in 2008/09. And I mean an actual global recession, not just the media recessions we seem to have once or twice a year.

You can get a better idea of why this is the case considering a couple of examples below. Chart two shows Asian iron ore demand (ore imports) over the last few years.

Chart 2: Asian iron ore imports

Notice how demand had been steadily rising through the GFC and subsequent global turmoil. I’m guessing that if iron ore demand can hold up through the GFC, then you’d need to see something truly horrendous on the global growth front, to see demand for iron ore take a sustained hit now. And it’s not just iron ore. Chart 3 below also shows a similar pattern for copper.

Chart 3: World copper consumption

The fact that volumes growth remains strong even during periods of global recession would have to provide significant support to commodity prices. Is the boom over? The above charts suggest it isn’t, but even if that is the perception and commodity prices do decline further, volumes aren’t likely to fall, which of course will underpin earnings growth for our miners.

One simple explanation for that can be seen with a simple reference to China. Its economy is about 30% larger now than what it was in 2008. Even if Chinese growth slows to between 7-8%, that’s immaterial as far as commodity demand is concerned. In a year or two and on very modest growth assumptions, China will be close to 50% larger than in 2008. That is significant, that is the real story just there, not if China slows to 7% growth – and that’s just China.

So to reiterate, it’s unlikely that we’ll see the 60% earnings decline that current multiples require – even if global growth slows.

Don’t forget that our major miners already appear to have the end of the commodity boom priced in anyway – they never truly recovered. Think about the fact that both prices (USD) and volumes for bulks are above 2008 peaks – iron ore prices are roughly 123% higher. Yet BHP is trading about 37% below its 2008 peak and Rio is off about 64%.

In conclusion then, global growth may slow, or it may not. But it doesn’t matter given current earnings multiples and the resilience of global commodity demand, even in the face of serious recession. Either way, our miners are cheap and ripe to purchase on three to five-year view.