Are Iron Ore Producers Now A Valuation Trap?

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By Rudi Filapek-Vandyck, Editor FNArena

It's not the first time that a gap has opened up between the price of a commodity and share prices for producers of that commodity and if history tells us anything it is that this time won't be the last time either.

Experts, analysts and market commentators across the board have once again found common ground in pointing out that share prices of Atlas Iron ((AGO)), Grange Resources ((GRR)), Rio Tinto ((RIO)) and other producers of Australia's number one export product, iron ore, have fallen significantly in recent months while the price of iron ore itself has remained remarkably stable around US$135/tonne.

This has led to the predictable knee-jerk response that investors have lost all sense of correlation and of reality by marking down those share prices much deeper than what would seem justified on the basis of movements in the spot price for iron ore. The underlying suggestion is that beaten down share prices for Atlas Iron and the likes represent an obvious buying opportunity for daring investors. But the important question has to be asked: is the share market really that transparent in that an obvious sector full of buying opportunities is now on offer, just like that: up for grabs for whomever wants to make an obvious profit?

Whatever happened to: there's no such thing as a free lunch in the share market?

There's no denying share prices for the iron ore sector have been hit particularly hard thus far in 2013. Atlas Iron shares, for example, have almost halved since February. Atlas Iron and Rio Tinto have also seen short positions in steady accumulation these past weeks. Admittedly, the combination of sharp sell-offs, rising short positions and experts calling stocks cheap is likely to fuel the next rally, but is there a deeper message investors might be missing?

It's not like this hasn't happened before. In fact, two very notable examples of similar processes have taken place in recent years; first hit was the uranium sector in early 2007 while gold stocks have gone through a similar process since late 2010. The common denominator between all three sector de-ratings is that equity prices started weakening before there was any sign of weakness in the price of the related product.

In all cases there was the usual knee-jerk response from analysts and experts: equity prices are cheap, investors should jump on board an obvious buying opportunity.

We all know what has happened with share prices of uranium stocks and gold producers since de-ratings started: they simply turned cheaper, and cheaper, and cheaper. Sure, in between there have been temporary rallies. The last one for the gold sector took place late last year and deflated leading into the new calendar year. But that type of information is only interesting for traders. For investors it's the long term trend that counts and the long term trend for both uranium and for gold has been down.

Many investors have accumulated investment losses during these prolonged de-ratings. With iron ore displaying the same characteristics as uranium and gold back then, the same is likely to re-occur this time around. This, of course, will not deter experts and commentators to continue ventilating the idea that share prices look cheap and undervalued. It's what has happened during de-ratings of uranium and gold stocks and it is happening again with iron ore.

What these experts are missing, in my view, is that other key characteristic that all three sectors have in common: a widespread realisation that a downward trend for the product price has kicked in. It's difficult to deny there's now a downtrend in place for both uranium and gold, which, by the way, doesn't mean there cannot be a resumption of a new uptrend at some point later. But a downtrend is in place, regardless. Even major producers BHP Billiton ((BHP)), Rio Tinto and Fortescue Metals ((FMG)) expect the price of iron ore to weaken in the years ahead.

So the only point of discussion then becomes how quickly and how far will the price fall? Is US$100/tonne by the end of this year too far too soon? Probably. But last week's update on price projections by Credit Suisse suggests iron ore prices sub-US$100/tonne in 2014 are a genuine possibility. And even if that's too pessimistic, it'll happen in 2015. If not, 2016 will be the year.

It seems a bit silly to have a range as wide as four years without any certainty that iron ore prices during these years will actually fall below the pivotal price level of US$100/tonne, but that's not what this sector de-rating is about. It's about the fact that nobody knows anything with a 100% certainty, but one thing's for sure and that is the underlying trend is now negative. Iron ore will be priced at lower levels in years ahead. We just don't know exactly how low and when exactly.

The market psyche has changed.

Before anyone starts shouting: this is ridiculous! Consider that back in 2007, when spot U3O8 ("radioactive yellow cake") was climbing towards its peak at US$136-138/lb, nobody knew when exactly the turnaround would arrive, or how deep it would take the thinly traded spot price, but those investors who understood the message and acted accordingly, ignoring the misguided calls from analysts and experts, have managed to escape worst case scenarios and collateral damage to their investment portfolios.

Note the most promising of all U3O8 producers in Australia, Paladin Energy ((PDN)), saw its share price peaking at $10 back in 2007. Six years later, and some temporary but hefty rallies in between, the share price is trading below $1 ($0.92 as I write today's analysis). Australia's pre-eminent gold producer, Newcrest Mining ((NCM)), has seen its share price more than halve since peaking at $42 in late 2010-early 2011. Its last traded share price is $19.18.

It seems but a faint memory now, but Newcrest shares have posted a few temporary rallies on their way from $42 to $19.18. In 2012 the price jumped from $21 to $35, but similar to what has happened with share prices in the uranium sector, those rallies ultimately ran out of steam and the share price resumed its downtrend afterwards.

This may well become the blueprint for iron ore stocks going forward. Rallies will happen because share prices look oversold and undervalued, but ultimately the underlying downtrend will re-assert itself.

All else being equal, the slide in the price of iron ore will affect the big diversifieds in the sector differently than smaller, single commodity producers such as Atlas Iron and Fortescue Metals. Rio Tinto and BHP Billiton already have their eyes firmly on major cost reductions and non-strategic assets are wearing the For Sale sign. Both Rio Tinto and BHP Billiton are the lowest cost producers in the sector and both have further production increases on the agenda. It is very unlikely their share prices will experience anything similar as to what has happened to Atlas Iron over the past two months, but they will be affected nevertheless.

I think it is very likely both BHP Billiton and Rio Tinto will have to get used to see their share prices trade at a discount to Net Present Value, as both already are. Investors better forget about Rio Tinto shares reaching for $100 or BHP shares revisiting the $50 mark. With iron ore prices now in a downtrend, I think those valuations/price targets are best buried and forgotten about. Especially since a similar case can be made for copper as well, not to mention crude oil.

Investors should note last week's sector update by Credit Suisse lowered the investment banker's price target to $70 for Rio Tinto and to $35 for BHP Billiton. Both price targets are arguably below numbers put forward elsewhere, plus they are based upon price forecasts that are well below market consensus, at least at this point in time. Both price targets are also above where share prices are today. I would offer the underlying key message from CS's market update is not whether $70 and $35 are correct or not, that's for the next few years to decide, but maybe investors should tone back their expectations and re-assess their risk positioning?

The years past have shown BHP Billiton shares can easily rally to $35 and beyond during times of increased investor optimism and general risk appetite, it's staying above that price level that has proved more of a challenge in a world that is no longer steaming ahead, but offering lots of changes and challenges instead. The same can be said of Rio Tinto. Fact remains: if it wasn't for the annual dividends paid out by both companies, shareholders would have had nil rewards for holding on to their shares since 2006; that's seven long years, and counting. (The ultimate irony is, of course, that nobody actually buys resources stocks for their dividends).

One question has to be asked though: what are the chances investors are wrong in their assumption?

In the world of commodities the future is always uncertain with lots of potential for surprises, either way. Note that analysts at CIMB hold a much rosier picture than Credit Suisse does on the premise that scheduled production increases won't happen as planned and because higher cost Chinese production will keep the price for iron ore higher for longer. India, not that long ago the world's number three exporter of iron ore, has already supported the price by removing itself from the global seaborne market. It is not impossible that more bad news for India's domestic production can turn the country into an importer in a few years' time.

Maybe Quantitative Easing can finally push the Japanese economy on a sustainable growth path? Maybe Europe can work out a small miracle (rather call that a big one) and re-establish sustainable growth? China could surprise to the upside too.

There are always possibilities for upside surprises and for turns that no-one can foresee this far in advance, but within this context copper should be on everyone's mind. A few years ago already some experts started to predict a market surplus would emerge. That never happened, mainly because production from the main, established mines consistently failed to meet targets. This year, however, it would appear the predicted market surplus has finally arrived. As a result, copper producers in the share market have received the same treatment as iron ore producers and as gold and uranium stocks before that.

Maybe that's the message that should ultimately be on investors' mind: it may not necessarily happen this year, or even next, but it will happen eventually.

Adjust your strategies accordingly.

(This story was originally written on Monday, 08 April 2013. It was published on the day in the form of an email to paying subscribers).

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Rudi On Tour in 2013

– I will present and contribute during the 2013 National Conference of the Australian Technical Analysts Association (ATAA) at the Novotel in Sydney's Brighton Beach, June 21-23

– I will present to members of AIA NSW North Shore at the Chatswood Club on Wednesday 11 September, 7.30-9pm

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