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Mining Stocks: Be Selective

By Yiannis G. Mostrous on January 12, 2012

Price volatility created an unstable investing environment for materials in 2011. With 2012 already underway, it’s obvious that the same issues that dogged markets last year remain in place.

Europe remains at the center of global economic instability and will remain so until the markets believe that the eurozone has taken credible measures to tackle the sovereign-debt crisis. Furthermore, China’s economy continues to slow and market participants fear a hard landing for the economy. Although we don’t expect a hard landing for China, investors should gird themselves for more volatility until the economic picture clears later in the year.  

Regardless of the macroeconomic uncertainty, mining stocks have several positive attributes. For starters, valuations remain attractive, and the companies have continued to make necessary investments for future output growth.  

As we noted recently in the Global Investment Strategist, when management ramps up capital spending, it’s a strong indicator of confidence that the underlying business is growing. In fact, there’s no better forecaster for future profit growth.

Investors, however, tend to view such moves skeptically, almost always waiting for signs that spending is paying off before buying stock. In fact, capital spending in an uncertain business climate often triggers selling, particularly when it involves raising debt and/or equity capital. This seems to be the case in the mining industry today for virtually every metal or mineral.

It’s true that a contracting global economy will affect super miners’ earnings and share prices, just as it will with every other mining company. They’re rarely the biggest winners from a rising market either. But at the end of every cycle, these miners emerge ever more powerful and ready to move aggressively on the global stage–even as rivals often falter and diminish.

Given the uncertain investment environment, investors should allocate funds toward large, diversified miners such as Rio Tinto (NYSE: RIO). These firms are in the best position to weather the storm.

Rio Tinto is one of the world’s largest miners, the second-largest producer of seaborne iron ore, and a major producer of copper, coal and aluminum. It is a producer of diamonds and gold, and it also has industrial mineral interests, primarily borates and titanium dioxide feedstock.

Rio Tinto remains in expansion mode with USD27 billion worth of projects in the pipeline and USD35 billion worth of projects in advanced study.  Unlike some other majors, Rio Tinto made the ill-advised decision in 2008-09 to cancel some key investments, a move that visibly hurt the company when Rio Tinto restarted in these projects. In some of the company’s Australian operations, for example, restarting projects has led to an almost doubling of capital expenditures.  As a result, Rio Tinto has now decided to continue investing throughout the cycle.

Rio Tinto is well diversified and its major operations are mostly low-cost. It has one of the strongest balance sheets in the industry, and been steadily reducing its debt. Rio is also in the process of completing a USD7 billion share buyback program. The stock trades at 1.84 times book value, a relatively undemanding valuation given the company’s solid 25 percent return on equity.

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