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A commodity super-stock you should know

It seems to be that if you ask any stock market analyst if the price of iron ore will fall, the answer is an undeniable yes. Ask them when and they’ll say, “Argh this year, in the fourth quarter” or, “In 2015, we expect the to average to be [insert price]”.

Warren Buffett, arguably the best investor of all time, believes many of us spend too much time focusing on what’s knowable and not enough time on what’s knowable and important. Interest rates, recessions and commodity prices are important but they’re not knowable because we cannot accurately predict what they’ll be and when. At an MBA talk for the University of Florida he said: “Whether it is important comes down to valuation.”

In the resources sector, a price-taking industry, there is no differentiating between products (other than quality), and buyers are unlikely to differentiate between producers for anything other than price. Therefore the prices of stocks in the industry are relative. Relative to their peers and relative to the cost of production.

Commodities companies produce will change in price unpredictably and iron ore could well fall in the second half of 2014. Iron ore producers like Rio Tinto Limited (ASX: RIO), BHP Billiton Limited (ASX: BHP), Fortescue Metals Group Limited (ASX: FMG) and smaller companies like Atlas Iron Limited (ASX: AGO) and Mt Gibson Iron Limited (ASX: MGX) will be hoping a price of below $US100 per tonne doesn’t eventuate.

My iron ore pick

BHP and Rio – the most diversified of the five producers – have the lowest cost of production. Rio claims to be able to dig-up and ship its high quality Pilbara iron ore for less than $US50 per tonne. Even if the bearish analysts are correct, Rio will still turn a profit. Just less of it.

However, Rio’s recent track record has proven that having diversified operations can be more detrimental than accretive to overall earnings. Outside of iron ore, Rio’s aluminium and energy assets were dragging on earnings and, until FY13, forced the company to post massive losses.

In the long term, iron ore and coking coal will continue to be used to build infrastructure such as railways, buildings and in the transportation industry, whilst aluminium’s use as a lightweight metal will increase. So too will the use of copper.

If you’re bullish on the resources sector and iron ore in particular then Rio Tinto is where your money should go. Its low cost of production will enable it to survive in almost any conditions and its shares are currently much cheaper than rival BHP. BHP, with its greater earnings from coal, petroleum and copper is a much more diversified and safer investment. Fortescue, with its huge debt to equity ratio (currently at 240%) adds more risk to an already risky industry, and has a higher breakeven point than Rio, however it could also be more rewarding if iron ore prices maintain their current levels.

Foolish takeaway

You may not realise it thanks to all the doom and gloom forecast by news channels and analysts, but both BHP Billiton and Rio Tinto have outperformed Commonwealth Bank of Australia (ASX:CBA), National Australia Bank Ltd. (ASX:NAB), Westpac Banking Corp (ASX: WBC), CSL Limited (ASX: CSL) and the two supermarket giants in the last 12 months! This is testament to Buffett’s contention that too many people focus on what’s knowable and not enough on what’s knowable and important.

3 high-risk/high-reward resources tips for your portfolio

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Motley Fool Contributor Owen Raszkiewicz does not have a financial interest in any of the mentioned companies. 

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