Should you hit the panic button on mining stocks? Renewed fears about the survival of the sector have sent a number of household names in the sector on a sharp nosedive this morning.
It's scary to watch BHP Billiton Limited (ASX: BHP) plunge 5.4% to a 10-year low of $21.89, while Rio Tinto Limited (ASX: RIO) tumbled 5.1% to a more than six-year low of $46.27 this morning.
This is setting up the two ASX majors to become the biggest contrarian investment since the Global Financial Crisis (GFC). I'll explain later.
For now, we can thank Swiss mining giant Glencore for the selling stampede as the stock slumped close to 30% in London last night as it was hammered on two fronts.
Comments by Investec that there is zero equity value in Glencore and fellow UK miner AngloAmerican if commodity prices remain at current levels. This means their shares will be worthless.
What's more, traders are pricing in a more than 50% chance that Glencore will not be able to meet its debt repayment and the miner has a big pile of that! About $US30 billion to be exact and the market has little confidence in its plan to pay off a third of its debt through a capital raising.
Who would participate in a new share offer if the shares aren't worth anything without a recovery in commodity prices, which could be more than a year away?
This isn't the time to dump BHP or Rio Tinto. Remember what Warren Buffett said about being greedy when others are fearful? Well, fear seldom comes in bigger doses than this and there are two reasons why I think BHP and Rio Tinto are the best contrarian value investments you can make.
The first speaks to the principle of natural selection – or survival of the fittest. There isn't a more bullish buy signal for both stocks than the collapse of Glencore and Anglo American (not that I am calling for such an outcome).
Glencore produced 1.5 million tonnes of copper and 146.3 million tonnes of coal in 2014. This accounts for around 8% of global copper production and 2% of the world's coal output.
That may not sound like much but the thought of the removal of major supply sources of raw materials is enough to turn sentiment towards the industry.
BHP and Rio Tinto are not in any danger of falling over even at current spot prices thanks to their low production costs and the weakening Australian dollar.
While it's questionable if they can sustain their dividends, there is little doubt even among the bears that they will be among the last men standing.
What's more, the brutal downturn in the sector is driven more by cyclical issues than structural. We have not figured out a way to use significantly less steel for building bridges and the like.
The second reason is the "washout". The end of every bear market (and miners have been in a bear market for the last four to five years in case you haven't noticed) is marked by complete capitulation.
It was certainly that way in late 2008 and early 2009 – before the end of the GFC-induced bear market.
In many respects, the extreme negative sentiment towards the mining sector reminds me of the darkest moments before the dawn of a new bull market – not that I am predicting a bull market for commodities is around the corner.
But if you buy the strongest stocks in the most cyclically depressed sector, you will almost always come out smiling at the other end.
You just have to be patient and take the volatility in your stride – and that's always easier said than done.
