Iron ore prices are in a sustained bear market at present, which reversed most of the commodity’s price gains over the past year. With most producers forecasting price declines and adjusting supply plans accordingly, the big driver of the recent bear market has been on the demand side. Markets are nervous about the US/ China trade war, with the latter country driving a large share of global iron ore demand.
China signalled growth concerns when it allowed the yuan to weaken in August, presenting a double whammy for iron ore producers. A weak yuan limits the purchasing power of Chinese industrial users of the commodity, since they pay yuan for a commodity that is priced in US dollars. Weaker Chinese growth means less urbanisation, less industrial activity and less iron ore demand from China. This combination of factors paints a bearish picture of iron ore, which markets have now factored in to both the spot and futures market.
Iron ore prices (Credit: Business Insider)
Iron ore producers are down slightly less than the broader market, with BHP Billiton (ASX: BHP) down 13%, Rio Tinto down 17% and Fortescue Metals down 16%. This is because investors and management teams alike foresaw an iron ore price correction and were thus prepared for it.
Projections for iron ore demand (Credit: Merlon)
If the market is not prepared for it however, miners will generally decline by more than the spot price of the commodity. This is because miners make a profit from the difference between their production costs and the current commodity prices. To put that into perspective, a company which mines iron ore at a cost of $70/ tonne, makes $10 a tonne when the iron ore price is $80. If the iron ore price rises 25% to $100 a tonne, the miner sees their profit triple even if production is flat. This effect can however work in reverse, with a 20% selloff in iron ore prices from $100 to $80 reducing profits for the producer in the example above by 67%.
Short Term Outlook
Management teams of iron ore companies expressed confidence in relatively strong demand levels for China, despite the trade war creating increased concern in financial markets. Bullish remarks from Fortescue’s (ASX: FMG) Chief Executive were also echoed by Rio Tinto’s (ASX: RIO) CEO, Jean-Sébastien Jacques. Given that the big 3 miners deal with a large suite of Chinese buyers and have a greater insight into iron ore demand than most investors, markets pay close attention to the outlook of mining executives. Iron ore executives moderated expectations on the upside and are thus more trusted by the market than management teams who always put a positive spin on results, regardless of fundamentals.
Australia’s recent record trade surplus, driven primarily by commodity exports, has contained bearish sentiment towards iron ore. China’s slowdown is particularly pronounced in industrial activity, which is still in contraction according to the latest PMI, and residential construction. Both are viewed as mature industries, that are not expected by to play as vital a role in China’s transition to an increasingly consumption focussed growth story. As such, they are expected to be a drag on the overall economy my many investors and gain a lower priority in additional rounds of stimulus from the Chinese government.
Long Term Outlook
Although the near-term fundamentals in industrial commodities are mixed, they are strong over the long term. Every year between now and 2050, China alone is set to move over 10m people into cities every year. This will create huge demand for commodities such as iron ore, which are needed to fund the development and expansion of cities. In three years, China used more concrete for the rapid development of infrastructure and housing than the US did over the entire 20th century. China is projected to have an urbanisation rate of 90% by 2050, putting it on par with much of the developed world. The only major region in the world not to be almost fully urbanised by the middle of the century is Africa, with a projected urbanisation rate of 66%.
China has a bullish economic outlook (Source: IMF; St Louis Fed)
There are many investment opportunities in the local mining sector that will benefit from urbanisation story in China, with BHP Billiton (ASX: BHP), Rio Tinto (ASX: RIO) and Fortescue (ASX: FMG) having been profitable investments for Aussie investors. Nevertheless, at current valuations, we would not recommend initiating a position in these companies. Iron ore prices have rallied off the back of an unexpected shortfall, which could soon be reversed. This trend, in addition to the sudden slowdown in China, paints a bearish picture for the sector, increasing the chance that investors will get a far better entry point.
How the Top Three Aussie Producers are Tracking
BHP Billiton (ASX: BHP) is the largest mining company in Australian and is often regarded as a bellwether for the sector’s health. They had to contend with unplanned outages in H1, leading to a second half earnings skew. This was positive for the business, since realised pricing was higher in the second half than in the first half. BHP earnt US$23.2bn in EBITDA for FY19, which was unchanged on the previous year. The currency change did however translate into some earnings growth when measured in Aussie dollar terms, but favourable FX moves cannot be relied upon over the long term.
One positive out of the result was a high ROCE of 18% in FY19. There has been a multi-year trend of ROCE improvement for the company, highlighting the strengths of BHP as a business. They plan to increase their ROCE to 20% by FY22, showing that further earnings quality improvement could be on the cards.
Rio Tinto (ASX: RIO) increased underlying EBITDA from $9.2bn to $10.3bn, with high iron ore prices throughout FY19 offsetting weak results in aluminium and copper. Like BHP, RIO also increased their ROCE by 4pp to 23%. Nevertheless, net earnings did decline by 6% because of challenging conditions across the parts of their business not linked to iron ore. Since most large miners produce multiple commodities, investors need to monitor every part of the business to ensure that they aren’t surprised by an earnings downgrade on the back of weakness in a commodity they didn’t know they were investing in.
Fortescue Metals (ASX : FMG) is different from BHP and RIO in that it produces a lower quality 58% grade of iron ore. This grade falls heavily in price corrections, because a greater percentage of buyers choose high grade iron ore when it is cheap. There are also concerns around whether China will tighten regulation around the use of Fortescue’s 58% grade of iron ore. They increased revenue by 45% in FY19, while underlying NPAT rose by 195% to over $US3bn. Nevertheless, with iron ore falling sharply, Fortescue will most likely lose out form the change.
Will we go into Recession?
2s10s inversion has been a timely recession indicator (Credit: St Louis Fed)
When investing in mining, it is important to have a view on the economic outlook since it has an outsized impact on commodity prices. Mining is a cyclical industry, and cyclicality influences everything from the right price an investor should be paying for a miner to its earnings trajectory over the next few years.
One indicator that is used to see whether the economy will go into recession is the 2s10s spread. When investors worry about the economic cycle, they prefer to buy long term bonds since they go up more than short term bonds. To illustrate why, suppose you held a $1,000 bond paying a $50 a year in interest for the next 10 years. Imagine interest rates suddenly fell by 5%, and new bonds that sold for $1000 now paid a 0% interest rate. Investors will clearly pay a lot more for the first one since it makes more money, pushing the price of the initial bond up. This effect is more muted over shorter time horizons.
This is why investors like longer term bonds as much as shorter term ones when they think the economy will contract. Bond markets have, in the last four market cycles, predicted contractions far earlier than the stock market. The difficulty is that the stock market generally rallies 13% over a few quarters after the first yield curve inversion. If history is any guide, now is not the time to exit the markets completely, but it is the time to invest more defensively.
One of the main reasons why investors initially bought mining stocks is their attractive dividends. Nevertheless, as BHP’s dividend cut in 2016 showed us, most of that income can be lost very quickly. Investors who are playing the mining cycle or believe in the fundamentals of the business would need to ask different questions, but investors who are after dividends may do better to look elsewhere.
Is There a More Set and Forget Way to Invest in Dividend Stocks?
Our international high dividend Vue, a selected list of international stocks with attracts no management or performance fees, pays an 8-9% dividend yield. For investors who also want to not tie all their assets to the health of the Aussie economy, an 8-9% dividend yield beats 1% in local banks. This is one of the many options that investors have, if they want to boost their income and get out of the trap of declining interest rates that has defined term deposits over the past few years.
One of the securities we hold in the Vue is Gaming and Leisure Properties Inc. This is a Real Estate Investment Trust (REIT) covering high quality properties in the United States. While gaming is a cyclical business, the beauty of the REIT is that it only controls the underlying real estate, not gaming businesses like casinos. Their properties are leased to experienced operators in triple net lease arrangements, which means that they will get a steady income stream for years. Their clients are large, safe and experienced gaming operators, which are very unlikely to go bankrupt. The attractive 7.11% yield significantly outpaces Aussie REITS, which typically yield 3-5% for properties of a similar quality.
We also hold a top 3 Global private equity firm, which manages over US$220 billion in AUM. PE firms run investment funds that buy out entire businesses, improve efficiency and profitability as they transform the operations of those companies, sell them at a profit. After this, the PE firm will close its fund an receive a large component of its performance fees.
This creates a volatile earnings stream, given the company is paid for their performance after a few years. For this reason, private equity as an industry tends to be poorly understood by investors. In a market obsessed with quarterly earnings, the great 20%p.a. long-term growth rate of a brilliant business with sustainable competitive advantages is completely ignored by the market. This creates a great opportunity for us to use our long-term investment mindset to our advantage, and lock in a 7.81% yield at 7.6x earnings.
The importance of quality yield explains why we still recommend stocks paying a 4-5% dividend locally, despite being able to easily find stocks paying much more. We would rather a 4-5% dividend that could sustainably grow to over 10% of the initial investment over a few years, than a 10% dividend for a company in terminal decline.
America is a great place to invest for dividends. There are numerous US companies that have not missed a dividend payment in a hundred years, have sustainable payout ratios and quality management. Given this includes two world wars, the Great Depression and the GFC, it is quite an accomplishment.
Typical issues which Aussie investors have with investing offshore include a more limited knowledge of companies outside, sky high brokerage costs at the major brokers and not knowing where to start. We side-step these issues through developing a platform called Macrovue, where a top performing fund manager identifies attractive international investment opportunities for us to look at. We pay $15 a trade for brokerage and have a clear direction on which economic trends we are investing in. As one of the only platforms offering managed portfolios without performance fees, it’s worth looking at a couple of the themes we are looking at. The portfolios each have several stocks that investors can pick and choose if they wish:
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