There’s plenty to like about the mining sector but some are questioning if the best gains are already gone given that it has been outperforming the broader market for at least the last two years.
One broker raising the red flag is Deutsche Bank, which believes the “easy capital gains” have been had as it downgraded BHP Billiton Limited (ASX: BHP) to “hold” from “buy” and Fortescue Metals Group Limited (ASX: FMG) to “sell” from “buy”.
But this doesn’t mean there aren’t standout buying opportunities in the market with the broker characterising FY17 as a period of rising commodity prices and falling costs, while FY18 saw still rising commodity prices but early signs of rising costs.
“We believe FY19 is likely to feature [commodity] price rises challenged, against both clearly rising costs and capex [capital expenditure],” said Deutsche.
“Earnings are likely to still be reasonable as there is room to give on margins and earnings still remain satisfactory (resulting in FCF [free cash flow] yields ~10%.”
What’s more, the balance sheets of our miners are among the best on the market with high cash balances and low debt. Several miners, including BHP and Rio Tinto Limited (ASX: RIO) are also in the midst of handing back capital to shareholders.
“Largest caps are pregnant with capital returns. We see potential for off-market buybacks [from] Rio Tinto (up to ~5% of group market cap) and BHP Billiton (up to ~9% of group market cap),” added the broker.
“Such returns are welcome (sic), particularly for those who can take advantage of franking, but are not often a bullish signal to buy the sector.”
One disturbing trend is iron ore. While Chinese steel prices are at a seven-year high, iron ore prices have not followed. This is one of the key reasons why the broker has cut Fortescue’s rating by two full-notches as the miner sells lower grade iron ore that trades at a big discount to the higher quality product from BHP and Rio Tinto.
It seems investors will have to go to the mid-caps if they want to find worthy buys as Deutsche has upgraded diversified base metal miner South32 Ltd (ASX: S32) and New South Wales coal miner Whitehaven Coal Ltd (ASX: WHC) to “buy” from “hold”.
The broker has a price target of $4.10 on South32 and $5.70 on Whitehaven, while it has cut its price target on Fortescue to $3.70 from $5.80 a share.
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Motley Fool contributor Brendon Lau owns shares of BHP Billiton Limited, Rio Tinto Ltd., and South32 Ltd. 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 Scott Phillips.