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What every investor needs to know about BHP Billiton Limited, Rio Tinto Limited and Fortescue

There are sections of the market which are currently looking overly expensive, yet they continue to attract investors like never before. Look no further than the big four banks, which have arguably been overpriced for the better part of the last six months but have still managed to achieve record all-time highs recently.

Then there are those other sections. The ones that many had been assuming would reap strong rewards for shareholders in 2014, but have since failed to deliver. I’m speaking of the nation’s largest mining companies in particular, which have thus far been far from impressive.

For instance, consider mining behemoth BHP Billiton Limited (ASX: BHP). A number of investors had the company pegged as being one of the most promising investments entering the new year following years of disappointing results. Rio Tinto Limited (ASX: RIO) and Fortescue Metals Group Limited (ASX: FMG) were on the same list – although iron ore prices were expected to gradually drop, their cost cutting and productivity improving initiatives were anticipated to propel profits and therefore share prices.

That has not been the case. The chart below reflects the stocks’ relative performance compared to the overall S&P/ASX 200 Index (Index: ^AXJO) (ASX: XJO) since the beginning of the year. While Westpac Banking Corp (ASX: WBC), the best performing bank so far this year, has risen 6.6%, BHP, Rio Tinto and Fortescue have dropped 1.4%, 9.3% and 16.9% respectively.

 

Source: Google Finance

Source: Google Finance

Based on these results (and analysts’ predictions at the beginning of the year), it could be argued that the miners are currently looking quite attractive. So is there value to be realised from the nation’s three largest iron ore miners?

Fortescue Metals Group Limited

Since hitting a high of $6.22 a share back in February, the pure iron ore play has dropped back to $4.86, putting it on a P/E ratio of just 4.7 for the 2014 financial year (based on earnings of 103.1c per share). This is much lower than the multiples that BHP and Rio Tinto are both trading at, being 14 and 10.6, respectively.

The reason for this could well be attributed to Fortescue’s massive debt and its higher production costs than its two larger rivals, which makes it a riskier investment as the commodity’s price continues to fall. With many analysts anticipating iron ore to drop below US$80 a tonne sooner rather than later, investors will need to watch the company’s production costs which are currently estimated to be around US$72 a tonne.

Rio Tinto Limited

Pessimism over iron ore prices is also affecting Rio Tinto which derives a huge portion of its earnings from the steelmaking ingredient. Rio Tinto currently maintains a far lower breakeven price than Fortescue, estimated to be around US$43 a tonne, and is also forecasting production of 295 million tonnes for FY14, up from 265 million tonnes in 2013. This increase in production could counteract at least part of the effects from the fall in iron ore price.

For me however, Rio Tinto is a stock to buy only if you’re more bullish on the commodity’s price. BHP is a more appropriate investment if you’re not so confident.

BHP Billiton Limited

BHP is the safest investment you could make in the mining sector. While it derives a large portion of its earnings from iron ore, it also has excellent exposure to coal, copper and petroleum under its “four pillar” strategy. Further, it is also expanding its potash division which it anticipates will drive earnings for decades after 2020. While its operations (and risks) are far more diversified than those of the other miners, it is far less susceptible to volatility in any one commodity price.

Shareholders will also enjoy greater returns when the miner’s net debt falls below the US$25 billion level. While it is currently sitting on a net debt of US$27.1 billion, this target could well be achieved by as early as August as the company continues to focus on improving productivity and reducing operating costs. It is likely that the miner will undertake a share buyback program which would, theoretically, push prices up over the long-term.

Foolish takeaway

Investing in the mining sector is not without its risks, but it could certainly reward patient shareholders in the long-run. For investors not so confident on the price of iron ore, BHP would definitely be your best bet.

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Motley Fool contributor Ryan Newman does not own shares in any of the companies mentioned.

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