I have to admit I've been stirred from my usual sangfroid by the constant surprise of commentators that leveraged iron ore stocks are falling. It is – apparently – sensational that leveraged businesses supplying a commodity (iron ore) with stagnating demand and blooming supply are seeing their share prices smashed. Just don't be the one who thinks that's the bottom and buys.
Just two weeks ago I warned readers that: "While there will always be short-term rebounds, don't fall for calls that the leveraged iron ore stocks are value investments because of their low P/E ratios." So far I've been proved correct, but I now believe I underestimated the challenges facing these nightmare stocks.
A fortnight ago I singled out Fortescue Metals Group Limited (ASX: FMG) and Arrium Ltd (ASX: ARI) because they are way too leveraged to make it into my universe of possible investments. The stocks are down 8% and 12% respectively, since I made that call, but I realise two weeks is a short period of time.
Back in January, I first sounded the alarm bell about these dangerous investments in an article titled: Is your portfolio ready for a slowing Chinese Economy?
At the time I conceded that the (historical) P/E ratios of Fortescue, Arrium and Rio Tinto Limited (ASX: RIO) looked attractive, but I stated categorically that, "I'm not willing to risk such exposure to the iron ore price." I duly warned readers that "if iron ore prices do take a dive in the next couple of years, it will be too late for investors in Fortescue, Arrium and Rio Tinto." Little did I know how quickly my fears would prove founded (that part was pure luck).
My central thesis was that slowing demand growth and greedy miners all producing more would lead to falling prices, and that the companies' profits would be undermined. That's been true across the sector: BC Iron Limited (ASX: BCI) is down 39%, Atlas Iron Limited (ASX: AGO) is down 42% and even the blue-chip and relatively diversified BHP Billiton Limited (ASX: BHP) is down over 6%.
So why are these stocks such a nightmare for their owners?
Put simply, the pain is far from over for these businesses. It wasn't until I read a strong piece in MacroBusiness that I realised just how deluded the iron ore miners have been. The chart below shows the projected balance between supply and demand:
So if profiteering is in your genes (as it is mine) then you're wondering how to profit from this lunacy. For my money, you wait (though my short-selling friends have been doing well). You wait until after some iron ore miners close up shop – to quote a true value investor I admire – wait until you can see the whites of their eyes.
