News reports that the chief executive of Fortescue Metals Group Limited (ASX: FMG) Andrew 'Twiggy' Forrest has been snapping up shares in the business at $3.98 suggests he's confident shares are undervalued at that price. So should you follow the leader and back Fortescue's potential to grow rich off Chinese iron ore demand?
While other miners like BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) have more diversified revenue streams, Fortescue is a straight bet on Chinese growth and subsequent demand for iron ore. The bull case for Fortescue is that we are currently at the bottom of a cyclical iron ore price range driven by supply and demand dynamics.
Investors could expect the share price of Fortescue and other iron ore miners to leave their own recent trading ranges on the first signs of an upward trajectory in the iron ore price returning. Evidently Twiggy Forrest is confident the cycle has approached its bottom, and Fortescue is especially sensitive to a lower iron ore price as its production costs are higher than its larger competitors.
Twiggy Forrest's management style is aggressive and entrepreneurial, as evidenced by the company's rapid growth and massive net debt pile accumulated to almost exclusively fund that growth. Fortescue is highly leveraged and a high stakes play for investors confident of an iron ore price rebound. The massive net debt which stood at around US$8.6 billion going into 2014, is being repaid at a good rate given the recent big profits on the back of a high iron ore price.
However, any protracted downturn and the worst case scenario remains disastrous. The debt is also denominated in US dollars and reportedly unhedged for now, meaning it's not impossible the company may one day face a perfect storm of a weakening Australian dollar on the back of falling commodity prices.
Investors have been warned, however selling for $4.22 today it's clear the considerable risks and uncertainties are well and truly priced into the stock. It trades on just 3.75 times earnings and a fully franked yield around 4% means it'll seem cheap if iron ore prices recover over the long term.
