If there was an award for the worst profit result of this earnings season, then BHP Billiton Limited (ASX: BHP) would without a doubt be one of the favourites to take home the trophy.
Although the market has brushed off the US$6.4 billion loss as a one off event, I think investors need to be far more sceptical when it comes to the long term prospects of this mining giant.
Here are three reasons why I think long term investors should avoid buying a single share of BHP:
1. No economic moat – Like every other mining company operating in the sector, BHP has little control over the price it receives for the commodities it gets out of the ground. Buyers are not going to pay more for a tonne of iron ore because it was shipped by BHP, and conversely, BHP cannot charge more for the commodity because it believes it has a superior product.
2. Basic Economics – Most investors would be familiar with the basics of supply and demand, as highlighted by the graph below:
When a commodity's price increases rapidly, new miners quickly enter the market hoping to capitalise on the opportunity and this rapidly increases supply. If the demand doesn't continue to increase at the same rate, which we have seen recently with iron ore and oil, the price quickly falls back to an equilibrium level.
Unfortunately for BHP, the basic nature of this relationship means that creating outsized profits over a long period of time is nearly impossible. This is an important point for investors to consider as it means businesses like BHP are likely to be cyclical and unlikely to be great long term investments.
3. Poor returns on capital expenditure – As highlighted in the chart below, BHP has invested billions of dollars worth of capital over the past five years, yet shareholders have suffered from declining profits over that time.
Source: Company Presentation
While most investors are hopeful for better returns in the future, BHP still faces a number of significant headwinds and this means there is absolutely no guarantee that a decent return will ever be achieved from these investments.
Foolish takeaway
BHP is a highly cyclical business which makes it a great investment for investors who can pick the top and bottom of cycles.
