Is it time to bail from the big miners as the sector takes another beating today with the price of iron ore crashing to fresh six-year lows?
Falling commodity prices are universally bad news for the likes of BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO) but using the iron ore benchmark to justify dumping the stocks is missing the point.
Sure, the price of the steel making ingredient is an important driver, but it isn't the only game in town when it comes to valuing the likes of the two mining giants.
In fact, there are three other key value drivers for BHP and Rio Tinto: operating costs, capital management and the exchange rate.
As the latest profit announcements show, the miners are winning the war on these fronts.
That's important because these three factors would have at least just as powerful an impact on the miners' return on equity (ROE) as commodity prices.
Investors should pay a lot closer attention to the ROE than the headline ore price as the former is a more important determiner of value.
According to data sourced from Reuters, the trailing ROE for BHP and Rio Tinto is hovering around 13%-14%, and that's better than the 11% ROE that National Australia Bank Ltd. (ASX: NAB) is producing.
I think Rio Tinto and BHP can sustain a double digit ROE over the next year or two, and that together with their dividend yield of about 7% (including franking) is reason enough for me to buy the stock on dips.
However, this call isn't without risk. If the iron ore price falls towards $US50 a tonne or below and stays there, then all bets are off. The iron ore price is currently standing around $US58 a tonne.
I doubt that will happen because of the cost of production argument. BHP and Rio Tinto are the world's lowest cost producers of any significance and it costs them around US$45 a tonne to produce the stuff.
Call me crazy, but I am more worried about the earnings risks facing our big banks as there are far fewer tailwinds supporting their businesses.
Shares in BHP are down 0.7% at $31.93 while Rio Tinto lost 1.2% at $58.52. Over the past five trading days, BHP shed close to 5% of its value and Rio Tinto is over 9% lower.
