Beware the iron ore yield trap
Aitken Investment Management
The global search for yield has found its way to all corners of risk asset markets. Anything with a demonstrable short-term coupon has been bid up in price and bid down in yield, in line with record low cash rates and bond yields.
In my view, this has become somewhat dangerous. In many Australian equity sectors, the risk of substantial capital losses now outweighs the attraction of “spot” dividend yields.
Buying cyclical equity sectors for “spot” dividend yield is potentially a capital destroying combination.
In general, when you are receiving an attractive “spot” dividend (or large scale buyback) from a cyclical stock, it is either the peak of the cycle or that cyclical stock has unsustainably reduced operating costs/capex, or potentially, both.
In this context, I believe it is right to be cautious on Australian resource stocks, but particularly iron ore producers. You only really want to own resource stocks when the underlying commodity is rising. They provide earnings, dividends, and share price leverage to the given commodity price. Of course, leverage works both ways and I am of the view that commodity prices, but particularly iron ore will continue to weaken from here.
Similarly, I would never buy a resource stock solely for its “spot” dividend yield. The dividend is the icing on the cake, not the cake. It’s also worth remembering that resource companies deplete their asset base every day. They can’t put off sustaining capex forever.
If we take a step back, the critical debate is the underlying commodity price and the given company’s place on the global cost curve.
The iron ore price rallied strongly after Vale's tragic dam collapse at the beginning of this year. As Vale's lost iron ore production comes back on over the next 12 to 18 months, there is every chance iron ore prices revert to the $60t to $70t range from the current $92t. It’s worth noting iron ore has already fallen -22% from the peak price of $118 seen in early July.
So far, Australia’s largest pure-play iron ore producer, Fortescue Metal’s Group (FMG), has seen its share price somewhat defy the -22% initial pullback in spot iron ore prices. History and gravity suggest this won’t persist.
Below is a chart of FMG vs. the 62% (high grade) iron ore spot price (green line). The historical correlation is tight, with the last three months the notable exception.
If we do end up with a $60t to $70t iron ore price as tight supply conditions ease over the next 12 to 18 months, then I believe you will see FMG’s share price re-correlate to the spot iron ore price. That may see FMG closer to a $4.00 - $5.00 share price.
So, in chasing FMG’s consensus spot dividend yield of 7.00%, you are potentially risking a capital loss of -39% to -51%. You could be digging yourself a big hole.
The final point I’ll make is iron ore is the last commodity still standing. In a world where bond yields are pointing to an extended period of slow global growth with low inflation, it is not a bull market for industrial commodities. Commodities are a hedge against inflation, and there isn’t any.
The chart below illustrates the performance of iron ore vs. copper, oil, thermal coal, and LNG. Over the last 12 months, iron ore is the only one with a positive price return. It's hard to see this lasting.
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