Last year's rapid recovery in mining stocks has left investors who bought during the first half of 2016 with big profits.
A fast resurgence in the price of coal and iron ore led to big gains. But this rate of recovery is unlikely to continue. At some point mining stocks will transition from being value buys to being fairly priced. As a shareholder in all three of the big miners, valuation is a subject I'm paying close attention to.
We're now in the middle of results season. Rio Tinto has already released its figures, which were better than expected. In this piece I'll take a look at the latest numbers from BHP Billiton(LSE: BLT) spin-off South32 (LSE: S32), and consider the mining outlook for 2017/18.
Profits rise by 390%
The headline figures from South32 were certainly impressive. Sales rose by 8% to $3,221m during the six months to 31 December. The group's first-half underlying operating profit rose by 390% to $691m.
Higher profits were backed by strong cash generation. Free cash flow rose to $626m during the half, meaning that 90% of operating profit was converted to surplus cash. The group ended 2016 with net cash of $859m.
Some of this cash is being returned to shareholders. South32 will pay an interim dividend of 3.6 cents per share, which is equivalent to a cash return of $192m.
How safe is the outlook?
South32 stock now trades on a forecast P/E of 9.2, with a prospective yield of 5.2%. These are attractive figures. But it's worth noting that first-half earnings of 9 cents per share only represent 41% of full-year earnings forecasts for 22 cents per share. The company admits that hitting guidance will depend on "a strong finish to the financial year".
Another point worth noting is that consensus forecasts currently suggest earnings per share will fall by 20% during the 2017/18 financial year, which starts on 1 July. South32 may outperform this guidance, but at current levels I'd view the stock as a hold, rather than a buy. It might make sense to lock in some gains at this point.
Bigger might be better
BHP Billiton benefits from a more diverse portfolio of assets than South32. But the outlook is remarkably similar. Earnings per share are expected to fall by 13% to $1.25 per share in 2017/18. This puts the stock on a forecast P/E of 13.8, with a prospective yield of 4.5%.
As we've seen with Rio Tinto and South32, current year performance is likely to be very strong. BHP expects to generate free cash flow of $7bn during the current year, which will be used to fund debt reduction and a big dividend hike.
Are the shares still a buy? One measure which suggests that BHP may still be cheap is the so-called PE10. That's a P/E ratio calculated using the current share price and 10-year average earnings per share.
I've calculated BHP's PE10 as 9.1. That suggests to me that the stock isn't expensive, relative to its historic performance.
As a long-term income buy, I believe BHP remains attractive. But for investors seeking capital gains, now may be a good time to reduce the size of your holding. I suspect that further gains will be slower, with a greater risk of disappointment.
The Brexit boost is over: what's next?
Mining stocks surged higher last year following the EU referendum. This was because the pound's devaluation meant that US dollar earnings became more valuable in sterling.
I suspect this profitable trade is now over. If you're wondering what's next in the Brexit playbook, then I'd urge you to look at Brexit: Your 5-Step Investor's Survival Guide.
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Roland Head owns shares of Rio Tinto and BHP Billiton. 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.