Why I Don't Trust The Bounce In Rio Tinto plc And BHP Billiton plc
Sometimes, the biggest and most convincing-looking share price moves can be short-term reversals during a longer-term trend.
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That concerns me when I look at the recent moves up for Rio Tinto(LSE: RIO) and BHP Billiton(LSE: BLT).
Their profits and share prices have been in down trend. Even after the shares' recent bounce up, Rio's share price is down 61% since 2011 and BHP's 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, I'm ignoring such urges and avoiding big miners, because I think a return to past glories seems unlikely.
The challenge is their inherent cyclicality. They produce a commodity product with little differentiation from other firms' similar products. Worse, the selling price for their output isn't 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 we're 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 12 years.
The trouble with iron ore at $41 now is that it was just $16 as recently as December 2004, and didn't top that level for the prior two decades. Historically, its price was stable for a long time.
I'm not expecting another fast-inflating iron ore bubble. I'm no macroeconomic expert, but even I'm aware that a key consumer of the stuff, China, is sitting on square miles of unused and unwanted property development and infrastructure. The growth figures for China's economy keep slipping, and in just about everywhere else in the world it's 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 even lower. Even allowing for price inflation over the last 12 years, $40 is a lot higher than $16. It wouldn't surprise me to see the base metal slip below $30 dollars.
Over-valued?
If a new, lower level is set to be 'normal' for iron ore, Rio Tinto and BHP Billiton look over-valued. Today's 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 don't trust the recent bounce in Rio's and BHP's 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 or years before venturing back into mining firms.
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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.
