Time to Strike on Iron Ore?
July 4, 2012, 5:43 PM
Time to Strike on Iron Ore?
Deal Journal Australia HOME PAGE
By> Robb M. Stewart
It may be early days, but speculation Europe can make progress resolving its debt crisis, coupled with the prospect of further stimulus in China and the U.S., is encouraging brokers to suggest possible plays on big names in Aussie iron ore.
Moelis & Co. analyst Craig Lang has two pair-trade ideas: going long Rio Tinto and short BHP Billiton, or going long Fortescue Metals Group relative to BHP or Rio, for investors looking to add some risk to their portfolio as their optimism is rising.
The premise is based on the companies exposure to iron ore, which despite weakening from highs last year has remained relatively stable this year, and still offers the big low-cost producers an attractive operating margin.
Rio, BHP and Fortescue are numbers one, two and three in iron ore production in Australia respectively, and the country in turn is the worlds biggest source of the steelmaking commodity.
Bloomberg News The Rio Tinto Group operations center stands in Perth, Australia
Mr. Lang said he expects Rios shares to outperform those of BHPs when investor risk appetite gradually recovers, thanks to the formers greater exposure to iron ore as an earnings driver. Rio outperformed BHP at the start of this year, although the tables have turned since February as, among other things, concerns have heightened over slowing economic growth in China and European debt, he said.
Companies with more concentrated commodity exposure tend to outperform their more diversified, less risky peers when risk appetite recovers, Mr. Lang told Deal Journal Australia. While both are diversified companies, the growth in Rios iron ore contribution has crowded out the contribution [to earnings] from other commodities.
He adds that if a hedge fund were to go long FMG and short Rio or BHP, the trade has historically returned between 30% and 45% in the three to four months following a recovery in risk appetite.
The call comes as investors consider the underperformance of the major mining companies against the broader market. BHP shares, despite a recovery in recent days, are still down roughly 5.7% on the start of the year, and Rios are down about 2.2%. The benchmark S&P/ASX 200 index has risen 2.9% in that time.
Deutsche Bank this week named both BHP and Rio among its top picks in the mining sector due to their low costs, high margins, quality growth and attractive valuations. That call came even as it decreased its forecasts for commodity prices for the second half of this year and 2013 by an average 5%even though it anticipates a rebound in prices in the fourth quarter of 2012 as growth in China picks up.
Jefferies analyst Christopher LaFemina in London, meanwhile, has published a research report in which he labeled dual Australia- and London-listed BHP the king of quality and the top pick in the U.K. mining sector. The report argued the market is underestimating the companys substantial competitive advantages, as well as the underlying value of its equity.
Moodys Investors Service appears to agree the market may not be giving BHP full credit.
A comparison of the two mining giants suggests BHP has an edge over Rio in terms of size and scale, product diversity, profitability and financial profile, Matthew Moore, a Moodys assistant vice president, said Wednesday after releasing a report on the companies.
Mr. Moore said that both have many similarities and proven abilities in developing and operating large-scale mining projects, but that BHPs petroleum division is the key differentiating factor relative to its mining peers. Indeed, he points out that the high-margin petroleum businessand Rios higher exposure to aluminumled to BHP on average maintaining higher margins and returns over the last five years.