Shares in Rio Tinto (LSE: RIO) (NYSE: RIO.US) and BHP (LSE: BLT) (NYSE: BBL.US) took a knock this week on news that prices of iron ore imports into China dropped by over 8%. Iron ore is the most important product for both of these diversified miners, and China is by far the biggest single market. What’s been dubbed as ‘the end of the mining supercycle’, with growth in China decelerating and increased raw material output catching up with slowing demand, is beginning to bite.
Opportunity
But the industry dynamics put both miners firmly on my watch list. The shares are likely to continue trading sideways this year, and I’ll be looking for weakness as an opportunity to increase my holdings. My thinking is based on three factors:
- Both companies are paying a decent yield at current share prices. The miners’ efforts at cost rationalisation, asset sales, cutting capex and exploration spend and courting investor sentiment should ensure dividends are increased;
- Longer term, demand and supply will come back into kilter. Rio and BHP are among the lowest-cost producers in the world, they have the scale to live through cyclical downturns, and they have mining operations on the doorstep of China and the big Asian markets;
- When demand and prices eventually pick up, the benefits of previous cost cutting will show through in increased operational gearing, i.e. a greater proportion of revenue increases will drop straight through to the bottom line. That’s an effect we’ve seen before in sectors such as house-building and engineering.
Weakness this year
There’s little doubt iron ore prices will come under pressure: the only question is by how much. Prices have dropped by over a fifth so far this year, to a multi-year low of $105 a tonne. Stocks in Chinese warehouses are high, and there are concerns about the financial viability of some of the country’s less efficient steel-makers. Both Rio and BHP expect production to move into surplus, though they’re less bearish than analysts at Goldman Sachs who forecast prices to average $80 per tonne in 2015.
So both miners’ share prices could be weak over the next 12 months or so. Both have significantly underperformed the FTSE 100 over the past 12 months, and could continue their losing streak for a while yet. But with dividend yields of around 4%, it’s a good time to look for buying opportunities. If you wait until the economics look better, chances are the shares will have already discounted it.