Holy iron ore, BHP Billiton…

Iron ore down 8% overnight

a woman

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I received an email this morning from Motley Fool General Manager, Bruce Jackson:  "Iron ore down 8% overnight. The Phillips curse has struck!"  I'd like to think I've got the power to move markets – but I don't claim (or have!) such grand abilities.  Then again, I was on Sky News Business yesterday afternoon telling viewers that Friday night's 2% iron ore price fall was NOT a buying opportunity.

What I didn't know at the time was that iron ore would fall another 8% overnight — its largest one-day fall in over four years. The price, riding high at almost US$140 per tonne only a matter of months ago, is now in real danger of falling into the double digit range, resting around US$104 at the time of writing. Of course, that's not news if you've owned iron ore miners, with Fairfax reporting that the industrial commodity has slumped 22% in 2014.

In that same article, Citi's Clarke Wilkins is quoted as saying: "[The] only positive ray of light is that $US80 a tonne iron ore has already been priced in, and/or multiples re-rate as long as the expected decline finally happens,"  Well it might be now, but that was after Citi downgraded its earnings expectations for BHP and Rio earlier this month.

Horse. Gate. Bolted!

If you owned iron ore pure-play Fortescue Metals (ASX: FMG) on January 1 this year, you're a solid 17% in the red.

Rio Tinto (ASX: RIO) shares are down over 10%, while even the Big (Anglo) Australian, BHP Billiton (ASX: BHP) — one of the best and more diversified miners on our market — is over 5% down, this year. Fortescue fell 4% this morning alone.

The damage is done… for now

By the time most investors (including many professionals) have updated their models to incorporate the lower iron ore price, the damage is done. It's the danger of investing using the rear vision mirror. Many investors will be licking their wounds and wondering how they managed to be blindsided. After all, China is still growing at a phenomenal rate and the miners are cutting costs faster than Tony Abbott is cutting National Parks.

Foolish readers, I trust I helped you to avoid the iron ore carnage.  We've been warning you for quite a while that iron ore could be a dangerous place to invest. As I wrote as far back as October 2012: "… the unusually high profits per tonne of iron ore may well be a thing of the past. "A miner selling iron ore at $150 a tonne might have been banking a profit of $60 or $70 with each tonne sold. With the price back down closer to $100 per tonne recently, that margin might have shrunk by up to 70 or 80 per cent. "You have to sell a whole lot more iron to make that margin back."

Avoiding the carnage

I also wrote: "Oh, and for what it's worth, put me down for a yes for iron ore, gold and bond bubbles." I'm not Meatloaf, but maybe 2 out of 3 (so far) ain't bad? Time will tell if I land all three.

In a Take Stock of June last year, Bruce pulled the threads together nicely. He quoted a paragraph I wrote to Motley Fool Share Advisor members: "Miners have no sustainable competitive advantage (the only advantage is being low-cost, but that only lasts for the life of the mine). They can't control their prices, and can't meaningfully reinvest their funds to create long-term business value."

If it sounds bleak, it's because it IS bleak. Bruce lamented missing buying BHP shares at $30. I reckon one day he might end up celebrating that "miss." He also dobbed me in for saying I'd consider buying BHP at $25. I note that's a VERY long way from today's $36 price. It's also NOT a prediction — BHP shares may never fall that far.

But it was a view formed after considering exactly the sort of commodity price crash we've seen in the last few days. Maybe BHP at $25 is overly conservative, but I'm not going to get caught paying a multiple of what might end up being peak iron ore earnings!

Buying in a boom is bonkers

Miners are inevitably cyclical — their profits ebb and flow with both commodity prices and economic cycles. As we saw with gold at near US$1,800 an ounce, buying commodities at a high point is a very risky proposition. It's not too long a bow to draw to suggest it would have been a gamble — and history suggests it was.

Iron ore at US$140 a tonne was only ever sustainable if demand kept growing at a faster rate than supply. What were the odds of that? Not very high. If you can pull iron out of the ground for US$70 or US$80 per tonne and sell it for US$140, it was money for jam. As I mentioned earlier, the 'iron rush' was on in earnest, and a huge ramp up in supply was the only likely outcome. High school economics tells us that excess profits get competed away — a fact that should be kept in mind, especially when the product you sell has no competitive advantage… it's called a 'commodity' for a reason.

"But BHP won't go broke…"

I understand the allure of mining companies. If you manage to buy the right one at the right time, and if commodity prices and volumes go your way, you'll make some money. But if they don't, or – more importantly for those of us who don't run mining companies — if you simply can't be sure, then they can be dangerous places to invest. No, BHP won't go broke any time soon. But as an investor, your job isn't just to avoid companies that go broke.

Qantas (ASX: QAN)Billabong (ASX: BBG) and Bluescope Steel (ASX: BSL) haven't gone to the wall either, but you'd be hard-pressed to fund your retirement if you were using the 'won't go broke' investment strategy and bought those companies! No, your job as an investor is to find companies that will compound your investment, hopefully many times, over the long term. And to do that, you need to find companies whose competitive advantages will let them sell more of their products or services, at higher prices, for a long time.

I don't know about you, but I couldn't see how iron ore miners fit into that description when the price was US$140 per tonne — especially when the risk of a lower price brought on by a spike in supply was an ever-present danger. Time will tell whether the current iron ore price is a new low, or simply a pause on the journey lower. Maybe it'll even rebound.

But as I've told Motley Fool Share Advisor members many times, one of the greatest tools at your disposal as an investor is the option to simply say three little words – "I don't know" – and move on. That's not a phrase you'll hear too often from many experts. Indeed, some commentators have taken me to task for using that very phrase. "If you don't know", they say, "what are you doing?"

The answer is simple: No-one is ever described as a 'know it all' as a compliment. Or, as Warren Buffett says: "I don't look to jump over 7-foot bars: I look around for 1-foot bars that I can step over." We'll leave the showy heroics to others, and focus on finding businesses we can understand, giving ourselves an advantage in the process. That's Foolish investing in a nutshell.

It's not heroic, it's not brash and we don't pretend to have a strong view on every investment option. Instead, we look for the best ideas we can find. Right now, that means there's not one mining company on our Motley Fool Share Advisor scorecard. I fully expect that'll change in time, by the way, but we won't be rushed.

Scott Phillips owns shares in Berkshire Hathaway.

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