Iron ore prices plunged during the second half of 2021, which was a positive year for commodity prices.
We delved into the top 5 iron ore producing companies in 2020 to spot the best risk-reward deal Mr. Market is offering at the moment.
To do this, we used a 14 metrics approach: 14 financial statements indicators that can help us rapidly screen these top 5 iron ore producers.
erlucho/iStock via Getty Images In our investment journey, we experienced that mining companies often offer a low risk and high reward opportunity when value investors are able to purchase high-quality businesses relatively close to the bottom of a negative commodity cycle.
In this case, we identify as a high-quality business a mining company having a low break-even cost of extraction, high net income margins, low debt levels and lots of cash in its balance sheet. In such a constellation, we minimize the risk that the selected mining company goes bankrupt as it can tolerate low commodity prices and make a profit. In case the commodity price goes even lower, then the company can still survive for a few years as it has a strong cash position and low debt. The lower the break-even cost of extraction is, the highest the chances our investment turns out positive. We identify risk as the event that our investment will fail to deliver capital gain in the future. Then, we do not define risk as market volatility, which is notably high for mining companies when market sentiment is negative. Value investors can profit on market sentiment and jump in high-quality companies when the commodity cycle is negative and release those businesses when the cycle is rampant and Mr. Market is overly optimistic. That is exactly what we mean for low risk and high reward.
2021 was a rampant year for the majority of commodities. Think about natural gas , crude oil , copper and aluminium prices. Instead, iron ore prices plunged during the course of second half 2021. Chart 1: 2021 Iron Ore price chart. Source: Trading Economics 1-year chart Iron Ore
Such a decline in price is mainly due to Chinese government restrictions on electricity consumption by highly energy intensive sectors. Policy makers in Beijing have imposed steel production cuts to reduce pollution by February 2022 when Winter Olympics will take place in Beijing. Evergrande scandal might have contributed to slow Chinese iron ore imports as well. Market analysts expect iron ore prices will continue to fall to $65 by 2025. China policymakers can drastically impact global iron ore demand as China has roughly 75% of iron ore imports worldwide.
As commodities are cyclical, we delved into the top iron ore producers to check whether we could find high-quality and undervalued businesses. According to NS Energy , the following 5 companies were the top iron ore producers in the world in 2020: Vale SA ( VALE ) with 300 million tons produced;
Rio Tinto Group ( RIO ) producing 286 million tons;
BHP Group ( BHP ), 248 million tons;
Fortescue Metal Group ( OTCQX:FSUMF ), 204 million tons;
Anglo American plc ( OTCQX:AAUKF ), 61 million tons.
As reported by NS Energy , the iron ore sector global production totalled 2.4 billion tons in 2020 according to the US Geological Survey .
We used a 14 metrics approach to rapidly analyse these 5 mining companies without delving into annual reports and company SWOT analysis. The 14 metrics are used as a screen indicating whether or not we should further investigate or monitor one of these 5 companies. It is in no way a suggestion to run to the Stock Market and buy one of these companies. As Warren Buffett said, the value of any investment is the present value of future free cash flows. So we should carefully spend some time on a DCF model before even consider to buy a stock. The 14 Metrics in Depth
The 14 indicators have been calculated using financial statements data included in the companies’ annual reports for years 2016, 2017, 2018, 2019 and 2020. In order to keep a certain degree of data consistency we did not consider year 2021 as not all these five companies already published their 2021 annual report. The reason for which we calculated the 14 indicators on a 5-year span is because the iron ore sector is cyclical and we did not want to have biased data by a negative or positive cycle. In addition, gains from value investments usually take time to materialize […]