Morgan Stanley goes bullish on big miners

Photo: Mark Kolbe/ Getty Images.

Morgan Stanley thinks it’s time to buy BHP and Rio Tinto.

So far, 2015 has been a year to forget for the mining giants, as commodity prices have tumbled and concerns have mounted about what exactly is going on in China.

BHP and Rio have lost 9% and 10% respectively in response. But Morgan Stanley thinks they’re now good value.

Their view is based on better cyclical demand, historically attractive valuations, a four-decade trough in company fundamentals and continued supply discipline.

Morgan Stanley analysts upgraded their view on Australia’s big two miners to overweight from equal weight overnight, believing a “tactical re-rating” of the resources sector is on the cards with a future uplift in commodity prices.

The near-term demand outlook is key to their call.

“Emerging markets and China in particular remain key to commodities demand,” the team wrote in a note to clients.

“In the next few months we expect the perception around this demand to improve. In particular the acceleration of financial and administrative stimulus policies in China in recent weeks should start to feed through in both actual activity levels and equity market expectations.”

The importance of an improvement in Chinese demand is demonstrated in the chart below. In 2014, China consumed around half of all commodity production of Copper, aluminium, zinc and iron ore.

On the back of improving demand led by China, Morgan’s base case scenario is for commodity prices to rise by 14% in 2016 before accelerating by a further 19% in 2017.

“Using those forecasts we estimate 19% upside to our overweight-rated stocks,” they note.

“That would be a sharp reversal from the experience in the last 18 months. This should trigger a tactical re-rating of the sector.”

Along with an improved demand outlook led by a recent uplift in fiscal spending in China, the bank also believes valuations are also attractive from a historical perspective.

“Valuation is attractive in a historical context both at sector and company level. That means a change in perception around commodity prices can have a significant impact on the shares in our view,” Morgan’s wrote.

The bank points out that the sector trades at historical lows since the global recession of 1982 both in absolute and relative terms using price-to-book (P/B) vs return on equity (RoE), something that is shown in the chart below.

“The sector’s absolute trailing P/B of 0.85 and RoE of 7.9% is the lowest level since the global recession of 1982.”

Morgan Stanley suggests that with returns on capital and equity currently sitting at a four-decade low it will likely ensure supply discipline is maintained.

“Together with weaker project returns this drives large scale cut back of new projects even at the industry’s cost leaders.”

“Furthermore, some of the cost savings made across the industry will prove unsustainable in our view. This could trigger additional capacity exits when some costs reverse.”

Following strong gains in overnight trade in London, shares and BHP and Rio are on a tear in early Thursday trade, rallying 3% apiece.

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