Contrarian investors like to find stocks that are out of favour with the market. When sentiment is negative then the true value of a stock can easily be overlooked. I’m trawling the underdogs of the FTSE to identify which of them may not deserve their sub-market PE ratings.
Rio Tinto (LSE: RIO) (NYSE: RIO.US) is the cheapest of the miners in the FTSE 100, with a prospective P/E of 10.2. That compares with 12.3 for BHP Billiton (LSE: BLT) (NYSE: BBL.US), the next cheapest. Both these diversified miners have retreated this year, underperforming the index by around 22%.
Super-cycle
Slowing growth in China has ushered in the turning of the decade-long mining super-cycle. The industry has cut back on ambitious development projects, taken a pick-axe to capital expenditure and operating costs, replaced deal-hungry CEOs with experienced mine managers and declared itself dedicated to enhancing shareholder returns.
That makes the sector fertile ground for the prospective contrarian investor. Mining is undeniably cyclical. Industry production of iron ore, which has accounted for over 80% of Rio’s earnings, is expected to move into surplus next year as increasing supply catches up with slowing demand.
But the cycle is bound to turn. BHP recently forecast growth in demand of up to 75% in some commodities over the next 15 years, with a bullish perspective on China and the country’s ability to manage stable, long-term growth as the population becomes progressively wealthier and more urbanised.
Attractive
Rio and BHP are attractive at this stage in the cycle for the same reasons: they have large, efficient, modern, long-life, low-cost mine assets. And they both have strong balance sheets. That will see them through the downturn, and in good position to exploit opportunities when demand strengthens.
One fan of Rio is broker Credit Suisse. It recently put a £39 price target on the stock, a 20% upside to the current £32.60. It said “with valuation, gearing and the corporate strategy generally heading in the right direction investors need only worry about future iron ore price expectations. If investors can convince themselves that a collapse in the price is not imminent then there need be no reason not to hold Rio Tinto shares into the future”.
Risk
There’s that iron ore supply/demand imbalance again. So there is some downside risk, but BHP’s bullish assessment is comforting. And if you’re taking a long-term perspective, the downside risk is relatively short term. I shall probably adopt a pound-cost averaging approach and add to my mining holdings progressively.