Shares in the big Aussie miners are well-placed to climb even if commodity prices stay in a lower range, according to Deutsche Bank.
Analysts Tim Baker and Joseph Kim noted that shares in mining stocks have tracked commodity prices lower this year. But they said the benefits of cost-cutting and reduced capital expenditure meant that mining shares still had upside even if commodities stay trading within lower ranges.
The pair said that since the China boom cycle started in 2004, mining stocks have been closely correlated to commodity prices. Looking at the last six years, the correlation to iron ore has been evident.
One of the reasons for the strong correlation is that as commodity prices rose over the past 13 years, mining companies threw all their efforts into extracting the resources with minimal regard for costs savings and operational efficiencies.
To put the rush for resources into context, Baker and Kim said that the ratio of capital expenditure to earnings before interest, tax, depreciation and amortisation (EBITDA) hit a peak of 200% in 2013, against a long-run average of 67%.
They noted that from 1975-2003, mining companies were able to derive strong profits despite weaker commodity prices. That changed from 2004 onwards, when trailing earnings often lagged behind:
In fact, the rate of annualised growth in commodity prices and mining share prices has more or less reversed between the two time periods.
The analysts said that the recent focus by mining companies on cutting costs and reducing capex means they are well placed to generate positive free cash flow in the years ahead.
They also expect external market factors to work in the miners’ favour.
They said that current valuations for the big miners looks cheap relative to the rest of the market, trading at a price earnings ratio of 12 times against a market average of 17 times.
In addition, commodity prices have stabilised off a lower base in recent weeks and the revised price range has been factored into earnings forecasts.
Lastly, Baker and Kim said that the overall picture for global commodity demand is positive.
Despite recent concerns about Chinese growth, the two analysts were relatively upbeat about China’s economy, noting that “the market has called the end of Chinese growth prematurely a number of times before”.
They said that Chinese steel demand is growing at 5% and that Chinese data surprises had shifted from negative to positive since the start of 2017:
Baker and Kim said that their model portfolio is overweight miners, and their top picks are Rio Tinto, South32 and BHP.