On Friday last week I read on this website that investors should buy Fortescue Metals Group Limited (ASX: FMG) "because shares in the company currently offer a fat, fully franked yield of 5.3%, with dividends per share being extremely well covered at over 2.5 times." I note that these metrics are forecast metrics and I must respectfully disagree with the author, who claims Fortescue could "make you a mint."
It's just as well neither of us own shares in the company, because since Friday shares are down over 6%, despite a 2.1% bounce so far today. An apt reminder of how a falling share price can easily wipe out a forecast, but not guaranteed, dividend yield.
Motley Fool contributor Andrew Mudie, who actually owns Fortescue shares, is more circumspect in his article that asks whether Fortescue is a bargain. He points out that "Fortescue looks cheap based on these metrics, however a further fall in the ore price will be bad news for shareholders."
Motley Fool contributor Owen Raszkiewicz, who owns December 2017 call warrants for low-cost iron ore miner, Rio Tinto Limited (ASX: RIO), also includes a word of warning in an article which concedes that "the short-term outlook appears quite bleak and risk-averse investors should probably look elsewhere for capital gains and dividends."
It seems the two contributors who are actually exposed to iron ore stocks are less bullish than another who is not. They seem to understand the risk that capital losses will wipe out dividends. In case you're not yet convinced, here's why iron ore stocks are not good dividend stocks:
1. Iron ore mining is capital intensive. That means in order to grow (or even maintain operations), companies need to use their cash-flow to invest. This constrains how much they can pay to shareholders in the form of a dividend.
2. Iron ore miners are at the mercy of the iron ore price, which they do not control. Iron ore prices could fall to below $80 a tonne, a point at which Fortescue is barely profitable (yet still indebted). For this reason, it's prudent for iron ore miners to keep big cash reserves to help them through periods where mining is unprofitable. This also constrains their ability to pay dividends.
3. The long term success of an iron ore company depends on riding out low prices until higher prices return. This can't happen unless supply comes off, usually because higher cost competitors go bankrupt or stop mining. It also requires demand to stay reasonably strong. As I have been arguing repeatedly since January this year, Chinese demand for steel is likely to weaken, at least in the short term. That means it will probably be a very long time before another sustained period of rising prices. As the market gradually wakes up to this fact, share prices of companies like Fortescue and Arrium Ltd (ASX: ARI) are likely to under-perform.
Rio Tinto has a competitive advantage as the lowest cost producer, and it's therefore a safer proposition than taking long-odds punts on the junior iron ore miners. However, in my view there are plenty of far superior companies on the ASX. The point of investing is to get great returns with minimum risk, and as Owen says, "risk-averse investors should probably look elsewhere."
In the last nine years, Rio Tinto has cut its dividend twice – by almost 50% in 2006 and by almost 70% in 2009. I'm not ruling out the possibility that investors in Rio Tinto or Fortescue could make good money over the long term. However, I am saying that I doubt it's worth the risk and that in any event, iron ore stocks are not good income stocks!
