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Why there’s plenty more pain in store for iron ore miners

Look around the table. If you don’t see a sucker, get up, because you’re the sucker.” – Amarillo Slim

My wonderful girlfriend, who often surprises me with her insights into my world, suggested last night that we should watch ABC’s The Business for “a bit of light-hearted entertainment.” That in itself was enough to get me laughing.

By the time Macquarie analyst Martin Lakos said, “it does appear there is still reasonably good underlying demand, despite the fact iron ore has come off a lot and overnight iron ore actually bounced, $3.20 a tonne,” I was feeling decidedly cheery.

Apologies to regular readers who are probably tired of hearing about slowing Chinese demand, centred around the fact that over 20% of residential apartments in China are vacant. But if like me you enjoy the comedy of commentary, let us take a little tour…

Possibly my favourite effort can be found in a Fairfax Media article titled: “Iron ore relief rally coming, predicts ANZ,” from May 29 this year. In that article, ANZ analyst Mark Pervan is quoted as saying: “Markets should see both steel and iron ore prices rebound off an oversold base. The point we’re seeing now is probably not indicative of current market conditions…” 

What is so brilliant about this one is that it manages to be half wrong on the rally, completely wrong about market conditions and to miss the point entirely over iron ore fundamentals. Even if there was a “relief rally,” the long term fundamentals were unchanged. The fundamentals of supply and demand pointed to further pain for iron ore miners, a fact I pointed out, at the time.

Data from Bloomberg, Chart courtesy of Asenna Wealth

2-year iron ore spot price, data from Bloomberg, chart courtesy of Asenna Wealth.

Iron ore is a commodity and the price for the commodity will tend towards the cost of production – allowing a margin for the lower cost miners, in most circumstances. The time (if ever) to buy an iron ore miner is after the higher cost competitors have gone bankrupt, not before. Commentators love to mention the fact that the weakening Australian dollar is an advantage for iron ore miners, because as the chart above demonstrates, it can mitigate the spot price falls.

However, the advantage isn’t that great, because the main ore producers are in Australia. What matters is being the cheapest producer, and even that advantage is over-rated, because competitors may sell ore at a loss, for extended periods of time.

Mining stocks are to investors like house prices are to virtually all Australians – an obsession. Never-mind the plethora of superior business models existing on the ASX, almost everyone wants to know about Rio Tinto Limited (ASX: RIO) and BHP Billiton Limited  (ASX: BHP). There may be a good time to buy these companies, but I don’t think it is now. Personally I’d steer clear, at least until competitors go broke.

I certainly don’t think long term investors should be buying shares in Arrium Ltd (ASX: ARI), Atlas Iron Limited (ASX: AGO), BC Iron Limited (ASX: BCI), and Grange Resources Limited (ASX: GRR). These companies are in perilous danger of becoming unprofitable, because iron ore costs them at least $80 per tonne.

Arrium is the worst of the bunch because of its high debt levels which it hopes it can pay off by raising capital from shareholders. The stock is down 35% today to 42c, and it’s trying to raise capital at 48c per share.

Here’s what long term investors need to know about Arrium: Avoid it!

I’ve been saying it since the price was more than 200% higher than it is today, I said it yesterday, and I’m saying it today. Sure, there might be some value in Arrium at some point, but there are plenty of better stocks available. If Arrium, Rio or BHP rebound strongly, I’ll miss out. But that’s ok, because I want to invest in stocks with high potential rewards, but limited downsides. That means avoiding debt-laden commodity plays like Arrium.

Personally, I particularly like this excellent long term growth stock. In fact, the stock goes ex-dividend very soon, and I think today might be a good opportunity to buy shares in it.

Unlike Arrium, it isn't exposed to commodity prices, or even fluctuating currencies.

Unlike Arrium, this growing company has been on my watch-list for years, and benefits from long-term, secular tailwinds. In fact, I've made returns of over 150% on a somewhat similar company. Regular readers may already be able to guess it...

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

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