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A bargain hunter’s guide to Fortescue Metals Group Limited

Credit: Generation One

Late last year, I wrote here about how I believed Fortescue Metals Group Limited (ASX: FMG) was regarded as the “ugly step-sister” to mining giants BHP Billiton Limited (ASX: BHP) and Rio Tinto Limited (ASX: RIO). Since the time of writing that article in November, a lot has changed for Fortescue, and my prophecy of it being regarded as Australia’s mining Cinderella appears to be playing out well.

Then and now

Back then, Fortescue changed hands at around $2.35 per share; today, it commands a 32% premium to that price (as of yesterday’s close of $3.11), despite the S&P/ASX 200 Index (ASX: XJO) remaining flat over the same period. Fortescue’s gains have been driven primarily by its underlying commodity of iron ore. The raw metal has surged on the back of increased Chinese demand to US$58.28 per tonne, according to figures from the Fairfax Press.

This upswing in share price ultimately begs the question: is Fortescue still a buy?

Strong operations

From an operational standpoint, Fortescue appears to be ticking all the right boxes. In its March quarterly production report, Fortescue shipped 42 million tonnes of iron ore, managing to reduce cash production costs by 6% over the quarter to US$14.79 per wet metric tonne.

Impressively, Fortescue increased cash balances by US$200 million over the quarter, whilst reducing net debt to US$5.9 billion. Fortescue also reiterated its guidance of maintaining cash production costs of US$15 per wet metric tonne for the remainder of the year, indicating solid margins if it continues to realise the average price of US$45.95 per dry metric tonne it did in the March quarter.

Chinese demand

Of course, the risk of investing in Fortescue is that its fortunes are captive to demand for iron ore, largely from China. With iron ore being a key ingredient for steel-making, housing construction (which increases with higher house prices) remains a key statistic to watch for Fortescue’s future.

Whilst recent figures from the Chinese National Bureau of Statistics revealed that house prices rose in 62 out of the 70 cities tracked in China in the month of March, the question remains whether or not this is sustainable going forward. I, for one, am not willing to bank on it given the strong run in underlying share price for Fortescue (implying a lot of this is possibly already priced in).

Accordingly, with rising risks of slowing demand for iron ore, now might be a good time to reassess your holdings and consider taking some profits.

Foolish takeaway

Investing in commodity producers can be fickle, with profitability being driven by factors of supply and demand largely beyond the company’s control. Accordingly, it requires a brave investor to continue holding these capital intensive businesses for the long term.

With risks of Chinese demand waning, I believe the company is far from a buy at current prices. Although Fortescue has proven naysayers wrong with its strong run in 2016, I believe it might be worth taking profits today and investing in something like The Motley Fool's Top Fully Franked Dividend Share For 2016 instead.

Forget BHP and Woolworths. This "dirt cheap" company. is growing like gangbusters, and trading on a 5.6% dividend yield, FULLY FRANKED (8% gross). With interest rates set to stay at these low levels for years to come, for income-hungry investors, including SMSFs, this ASX company could be the "Holy Grail" of dividend plays for 2016. Click here to gain access to this comprehensive FREE investment report, including the name of this fast growing ASX dividend share. No credit card required.

Motley Fool contributor Rachit Dudhwala owns shares of Fortescue Metals Group Limited. The Motley Fool Australia has no position in any of the stocks mentioned. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

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