Should you buy or sell BHP Billiton Limited and Rio Tinto Limited?

We're seeing a high stakes game being played out in the iron ore market …

| More on:

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

We're seeing a high stakes game being played out in the iron ore market – major producers BHP Billiton Limited (ASX: BHP), Rio Tinto Limited (ASX: RIO) and Vale. Inc are ramping up production significantly – right in the face of increasing stockpiles and declining prices. As a result heavy pressure is being placed on higher cost operators such as Fortescue Metals Group Limited (ASX: FMG) and some Chinese domestic producers.

However commercial history is littered with examples of such tactics backfiring on the instigators and this chapter may be no different. For one thing China (the major customer) is a controlled economy and is unlikely to allow too much of its own iron ore production to shut down. In the longer term China and other customers will be seeking to diversify supply – whilst enjoying the benefits of shorter-term gifts from the over-producers.

So how are BHP and Rio placed in the above context? Both are increasingly dependent (especially Rio) on the health of iron ore demand. Although both are increasing production, an overvalued A$ and falling realised prices tend to cancel the benefits. Return on equity is in decline, the necessity to hold more capital is increasing and these factors alone suggest their share prices are vulnerable.

On the bull side, BHP's increased production is estimated to be at an incremental cost of US$50 per tonne which is well below current iron ore prices. Rio has similar parameters. So there is no problem about both companies staying in business and generating positive returns. In addition both companies (especially BHP) have substantial franking credits available.

Although some investors were disappointed with BHP not going ahead with a share buyback, it is a sign of good management determined to retain a healthy capital position when faced with uncertain outlooks. In addition existing BHP shareholders may not want to miss out on the spinoff of the more dynamic NewCo.

Although BHP ($36.59) and RIO ($62.27) are excellent companies this doesn't make them good investments at current prices. With only moderate earnings growth (at best) expected over the medium term and an increasingly murky outlook, the margin of safety is insufficient in my view to justify any new investment.

Motley Fool contributor Peter Andersen doesn't own shares in the companies mentioned.

More on ⏸️ Investing

Close up of baby looking puzzled
Retail Shares

What has happened to the Baby Bunting (ASX:BBN) share price this year?

It's been a volatile year so far for the Aussie nursery retailer. We take a closer look

Read more »

woman holds sign saying 'we need change' at climate change protest
ETFs

3 ASX ETFs that invest in companies fighting climate change

If you want to shift some of your investments into more ethical companies, exchange-traded funds can offer a good option

Read more »

a jewellery store attendant stands at a cabinet displaying opulent necklaces and earrings featuring diamonds and precious stones.
⏸️ Investing

The Michael Hill (ASX: MHJ) share price poised for growth

Investors will be keeping an eye on the Michael Hill International Limited (ASX: MHJ) share price today. The keen interest…

Read more »

ASX shares buy unstoppable asx share price represented by man in superman cape pointing skyward
⏸️ Investing

The Atomos (ASX:AMS) share price is up 15% in a week

The Atomos (ASX: AMS) share price has surged 15% this week. Let's look at what's ahead as the company build…

Read more »

Two people in suits arm wrestle on a black and white chess board.
Retail Shares

How does the Temple & Webster (ASX:TPW) share price stack up against Nick Scali (ASX:NCK)?

How does the Temple & Webster (ASX: TPW) share price stack up against rival furniture retailer Nick Scali Limited (ASX:…

Read more »

A medical researcher works on a bichip, indicating share price movement in ASX tech companies
Healthcare Shares

The Aroa (ASX:ARX) share price has surged 60% since its IPO

The Aroa (ASX:ARX) share price has surged 60% since the Polynovo (ASX: PNV) competitor listed on the ASX in July.…

Read more »

asx investor daydreaming about US shares
⏸️ How to Invest

How to buy US shares from Australia right now

If you have been wondering how to buy US shares from Australia to gain exposure from the highly topical market,…

Read more »

⏸️ Investing

Why Fox (NASDAQ:FOX) might hurt News Corp (ASX:NWS) shareholders

News Corporation (ASX: NWS) might be facing some existential threats from its American cousins over the riots on 6 January

Read more »