Why the pain isn’t over for Fortescue and Arrium Ltd

Low P/E ratios can be deceiving.

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While there will always be short-term rebounds, don’t fall for calls that the leveraged iron ore stocks are value investments because of their low P/E ratios. In particular, leveraged iron ore miners like Fortescue Metals Group Limited (ASX: FMG) and Arrium Ltd (ASX: ARI) fail to reach the standards required of long-term value investors, in my opinion.

You can sum up their failure in one word: debt.

For example, Arrium has聽net debt聽of聽$1.975 billion. This is a company with a market capitalisation of $1.23 billion. It is forgivable that someone would have followed the advice of Cadence Capital when they started touting the company in September 2013. Indeed, for a while, they were right.

However it amazes me that that research, published by聽Eureka Report,聽fails to聽even once聽mention the word debt. Equally, there is “research” on Seeking Alpha that touts Arrium without once mentioning the word debt. Yet both pieces mention the “low” P/E ratio. This is just one example of how P/E ratios can be deceiving.

Arrium is down 30% since September 2013, and down over 47% since I warned investors to prepare their portfolios for a slowing Chinese economy.

Meanwhile, Fortescue had net debt of $8.7 billion at December 2013. At least its market capitalisation is larger than its debt, at $13.7 billion, but the large amount of debt does make the P/E ratio an unimportant measure. However, you do have to admire the company’s frankness: in a presentation given in February this year the company claimed it was “moving to investment grade metrics”. Sounds about right.

Those wanting to buy the negative iron ore sentiment, might want to instead buy shares in聽Rio Tinto Limited聽(ASX: RIO) or聽BHP Billiton Limited(ASX: BHP), though you won’t catch me making that sort of play. Nonetheless, the big miners are sure to benefit if and when the iron ore price recovers. In the meantime, they will easily survive because their break-even price is below $50 per tonne.

Motley Fool contributor Claude Walker (@claudedwalker) does not own shares in any of the companies mentioned in this article.

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